By Arnold Kling
The efficient markets theory, when understood not as teaching merely that markets are hard to beat even for experts and therefore passive management of a diversified portfolio of assets is likely to outperform a strategy of picking underpriced stocks or other securities to buy and overpriced ones to sell, but as demonstrating that asset prices are always an adequate gauge of value–that there are not asset “bubbles”–blinded most economists to the housing bubble of the early 2000s and the stock market bubble that expanded with it.
The distinction that he attempts to draw (many economists make the same attempt) is an interesting one. The claim is that prices can be “wrong” (quite far from fundamentals) in an efficient market. That may sound fine, but in order to believe it, you have to believe either:
a) when a price is wrong, it has about an equal chance of moving toward right or moving toward more wrong
b) when a price is wrong, it has a higher chance of moving toward right than of moving toward more wrong.
If you believe (b), also known as mean reversion, then you don’t quite believe that markets are efficient. I believe (b). There are times when I think that the market is wrong and I am willing to bet against it. I have a vague sense that I have done better than a purely passive investment strategy, but the fact that I do not seem to want to do a careful audit should give pause.
Read Posner’s entire essay, which gives an unusually balanced treatment of the issue of what the financial crisis says and does not say about the state of the economics profession.
A reader asked me to comment on Demyanyk’s Ten Myths about Subprime Mortgages. I agree with the substance but not the tone of the essay. If your point is that the crisis was caused by a combination of factors, then going through a subset of factors one by one and calling them “myths” is confusing.