The YES answer
Charles Wheelan in his famous book “Naked Economics” sounds very convincing in his presentation of this line of thought.
He writes: “The problem is that everyone else has access to the same information. This is the essence of the efficient markets theory”. No one can “outperform the market with any degree of consistency” (Wheelan, Charles J., 2010, p.163).
I like his analogy with picking the shortest checkout line at the grocery store.
We are trying to pick the shortest line, while absorbing the information about actions of the cashier (she may be a novice), and about the amount of load in shopping carts of other customers. We can win sometimes or lose, but on average, after many visits to the store, we spend about the same time as other customers. Why? Everybody has the same information as regards the situation at the store.
He admits, though, that “Neither the housing market nor the stock market has behaved lately in ways consistent with such a sensible and orderly view of human behavior…We are prone to herd-like behavior, we have too much confidence in our own abilities, we
place too much weight on past trends when predicting the future, and so on”.(Wheelan,
p.165) He praises behavioral economics for figuring that out.
But the conclusion is unequivocal, almost unambiguous: “The efficient markets theory is not going anywhere soon” (Wheelan, p.167). At least for financial markets the impact of
irrational behavior is short-lived and eventually not that important.
He says that even behavioral economists as investors follow the principle of efficient markets (is it convincing?).
Could the answer be NO?
After all, there are housing bubbles, inflated by “wild spirit” (as Keynes famously said), and irrational behavior of market agents. In fact, there have been several attempts to
question the theory of efficient markets.
The facts “on the ground” are irrefutable: during the bubbles “the walk is not random”, some behavior is very consistent; the impact of it is not short-lived and not insignificant. No way can we ignore that.
If a theory does not reflect the substantial features of the reality, it is not correct, right?
Not so fast, though. What about several centuries of remarkable economic, technological and, yes, social progress, despite the ignominious setbacks?
It looks like the efficient markets theory worked, and worked well.
Should it be thrown away because it is consistent with some facts and not consistent with others?
This is an epistemological question, a question about our cognitive ways.
Let me answer this question with another question (however unscientific it could sound): should Newton’s mechanics have been thrown away with the development of the quantum mechanics and the relativity theory?
It is well known that the relativity theory “includes” the Newton’s mechanics as a special case of speed, which is incomparable with the speed of light.
The epistemology of physics is just epistemology. It is applicable to economics as well.
Given all that, I think of the efficient market theory as a special case of a hypothetical general theory, incorporating all human traits, rational and irrational.
The human irrationality imposes some conditions (or limitations) on the efficiency. In math, because of the limitations, we can find only a local optimum.
Still, it is an optimum.
Likewise, the markets provide only local (in math sense) efficient optimum. It is a second best possible result. It could be greater without unreasonable losses, which we nonetheless
cannot ignore in the general theory.
The crucial thing to reflect in the hypothetical general market efficiency theory is the human nature, of course, which is a mixed bag of rational and irrational, and the
border line is sometimes blurred.
Take, for example, the penchant for extrapolation the current condition into the future. It may be a simple inertia (not rational), yet it may be a sophisticated correlation
model (partly rational).
Market fluctuations and the limited market efficiency
At first, let me remind the reader of the relations between the notions of market efficiency and market equilibrium. From Microeconomics 101 we know that the equilibrium price
defines the efficient quantity demanded and quantity supplied of the good. If the price is different from the equilibrium one, we are dealing with so-called deadweight loss, or just some loss of efficiency. So the notions of market efficiency and equilibrium are the two sides of one medal.
From this point of view, it would be interesting to see if equilibrium state of the market is possible (meaning: efficiency possible) under the conditions of market fluctuations.
Suppose the fluctuations are caused only by the changing expectations of the market agents. These expectations are partly rational and partly irrational.
At this point I am going to refer to my posts “Market Fluctuations Should be Explained In Microeconomics Textbooks” and Market Expectations Paradox”.
The idea was to make changes to the supply and demand curves according to the changes in the expectations and see how the price fluctuated. In the first of mentioned above
posts I changed the expectations rather arbitrarily, without any logic, to reflect the impact of irrationality on the market. Accordingly, the price fluctuated wildly.
In the second mentioned post I experimented with expectations, which extrapolated the current price change into the next month. Charles Wheelan was right, considering this
kind of behavior as irrational. Still, there were wild fluctuations of the price with no equilibrium.
Then I added another assumption. Suppose the market agents behave cautiously, making the expectations less and less ambitious, with progressively diminishing absolute changes. This kind of behavior may be regarded as more or less rational, or partly rational (as I’ve mentioned earlier, there is no such thing as absolute rationality).
In my opinion, it is rational to get rid of disturbing wild fluctuations of the past. The brain
notices the connection between the scale of expectations and the amplitude of price changes and suspects the causality between them.
With these two assumptions the market develops the trend to the equilibrium ( see the graph).
Does this mean the market will reach eventually the efficient state? I think so. But what kind of efficiency? Definitely, the fluctuations have caused some deadweight loss. So the efficiency state will be like a limited (local) optimum. Along the road to the market efficiency, there were losses.
literature cited:
1.Wheelan, Charles J. Naked Economics: Undressing the Dismal Science. W.W. Norton & Company,New York,London, 2010.
Creative commons license.
Andrew Zanegin's space 