Friday, May 30, 2014

This financial crisis did not disprove the efficient market hypothesis.

One of the most mentioned aspects about the current bank crisis is that in much it was a consequence of Alan Greenspan believing blindly in the efficient markets hypothesis, a hypothesis that became so thoroughly discredited.

Sorry… what efficient markets? With respect to the allocation of bank credit, the markets were completely distorted by the risk-weighted capital requirements, and so that hypothesis had no chance to be proven or disproven.

The capital requirements were and are much lower for what is perceived as absolutely safe, than for what is perceived as risky, and so the risk-adjusted returns on bank equity are much higher on assets perceived as absolutely safe than on assets perceived as safe.

In terms of the equity markets this would be something similar to the government multiplying the profits of investors, by paying them bonuses or similar subsidies, whenever they invested in shares with low volatility and not in shares with high volatility. Do you really think that would allow for an efficient market hypothesis to work free at its leisure?

I am not saying that the markets behave efficiently all the time but that, this time at least, it was clearly not the fault of markets, but the fault of dumb regulators.

PS. These comments were inspired by reading Chapter 1, "Primordial Seeds" in James Owen Weatherall's "The Physics of Wall Street" and which contains a fascinating description of the origins of the hypothesis and of its first and almost forgotten originator Louis Bachelier.

PS. I should acknowledge Tim Harford's arguments that though not the same do point in the same direction.