The efficient markets hypothesis Non-economists often surmise that the term 'efficient' refers to the speed at which operations take place on the stock market, and/or the cost per transaction. Since the former has risen and the latter fallen dramatically with computers, the proposition that the stock market is efficient appears sensible. Market efficiency is often alleged to mean that 'investors are a.s.sumed to make efficient use of all available information,' which also seems quite reasonable.

However, the economic concept of efficiency means something quite different from the normal parlance. In the case of the stock market, it means at least four things: that the collective expectations of stock market investors are accurate predictions of the future prospects of companies; that share prices fully reflect all information pertinent to the future prospects of traded companies; that changes in share prices are entirely due to changes in information relevant to future prospects, where that information arrives in an unpredictable and random fashion; and that therefore stock prices 'follow a random walk,' so that past movements in prices give no information about what future movements will be just as past rolls of dice can't be used to predict what the next roll will be.

These propositions are a collage of the a.s.sumptions and conclusions of the 'efficient markets hypothesis' (EMH) and the 'capital a.s.sets pricing model' (CAPM), which were formal extensions to Fisher's (pre-Depression) time value of money theories. Like the Fisher theories of old, these new theories were microeconomic in nature, and presumed that finance markets are continually in equilibrium. There were several economists who developed this sophisticated equilibrium a.n.a.lysis of finance. In what follows I s on the work of W. F. Sharpe.

Risk and return It seems reasonable, a priori, to argue that an a.s.set that gives a high return is likely to be riskier than one that gives a lower return. If an investor wants complete safety, then he can invest in government bonds. If a higher rate of return is desired, then he can invest in corporate bonds, or shares. The former hold the risk of default, while the latter can rise or fall unpredictably in price, and do not have a guaranteed income flow. Therefore there is a 'trade-off' between return and risk: a higher return can be earned, but only at the cost of a higher level of risk.

11.2 The capital market line Sharpe provided an explanation for this in terms of the theory of individual behavior discussed in Chapter 3. Once again, we find ourselves tobogganing up and down indifference curves.

The individual rational investor Sharpe began by a.s.suming that 'an individual views the outcome of any investment in probabilistic terms; he is willing to act on the basis of [...] expected value and standard deviation' (Sharpe 1964: 4278). An investor gets greater utility from a higher return than a lower one, and lower utility from an a.s.set with a high standard deviation than a lower one. This a.s.sumption enabled Sharpe to plot an investor's preferences in terms of indifference curves, with the two 'goods' being risk and return.

However, there was one twist compared to standard indifference curve a.n.a.lysis as outlined in Chapter 3. Risk is a 'bad,' not a 'good' and a consumer maximizes his utility by experiencing as little risk as possible. So the most desirable investment is one that gives a very high return with very little risk. Consequently, rather than being drawn to show that more of both goods is better, these indifference curves are drawn to show that more return and less risk is better.

With standard goods, the consumer prefers more of both, so the desirable direction to move in on the indifference map is up and to the right which means you feel better as you get more of both commodities. But with return and risk as the 'goods,' the desirable direction is more return and less risk. Sharpe drew expected return on the horizontal axis and risk on the vertical, so the most desirable direction was to the right which gave you more return and down which gave you less risk. The highest utility comes from the highest return and the lowest risk.

That takes care of the consumer's preferences. To complete the a.n.a.lysis, a budget line is needed as well and here again there was a twist compared to the a.n.a.lysis of consumption. Rather than the budget line being the investor's income, the budget 'line' was the spectrum of investments that an investor could make. Each individual investment was a share in some company,11 and all the information about them was reduced to their expected returns and the standard deviation of their expected returns. These could have any pattern at all some investments would have a very high expected return and low variability, others a low expected return and high variability, and so on. Each company could then be described by a point on the graph of return versus risk, where the horizontal position was the return and the vertical position was the risk.

This resulted in a 'cloud' of possible investments that were potentially available to investors, where the most desirable investments were those with high return the farther out along the horizontal axis, the better and low risk the lower down on the vertical axis, the better.

With this picture of investor behavior, Sharpe showed that the only investments that are rational for this investor are those that fall on the edge of the cloud of possible investments, which he labels the 'investment opportunity curve' or IOC (ibid.: 429). These investments give the highest return and the lowest risk possible. Any other combination that is not on the edge of the cloud can be topped by one farther out that has both a higher return and a lower risk.12 If this were the end of the matter, then the investor would choose the particular combination that coincided with their preferred riskreturn trade-off, and that would be that.

11.3 Investor preferences and the investment opportunity cloud However, it's possible to combine share-market investments with a bond that has much lower volatility, and Sharpe a.s.sumed the existence of a bond that paid a very low return, but had no risk. Sharpe linked bond and share investments with one further a.s.sumption: that the investor could borrow as much as he wanted at the riskless rate of interest. This a.s.sumption meant that, in Sharpe's model, an investor could invest some money in the riskless (but low-return) bond, and some money in risky (but higher-return) shares to create an investment portfolio.

This portfolio was represented by a straight line linking the riskless bond with a selection of shares (where the only selection that made sense was one that was on the Investment Opportunity Curve, and tangential to a line drawn through the riskless bond). Sharpe called this line the 'capital market line' or CML (ibid.: 425).

11.4 Multiple investors (with identical expectations) With borrowing, the investor's riskreturn preferences no longer determined which shares he bought; instead, they determined where he sat on the CML.

An ultra-conservative investor would just buy the riskless bond and nothing else: that would put him on the horizontal axis (where risk is zero) but only a short distance out along the horizontal axis which means only a very low return. Someone who was happy with the market return the return on an investment in shares alone would buy only shares. Someone who wanted a higher return than shares provided could do so by borrowing money at the riskless rate and buying shares with this borrowed money as well as their own (in the real world, this is called buying shares on margin).

All together now? At this stage, Sharpe encountered a problem. As well as every investor having a different set of indifference curves between risk and return, each would also have a different opinion about the return and risk that would be a.s.sociated with each possible investment. Thus investor C might think that investment F say the Internet company Yahoo was likely to yield a low return at high risk, while investor A might expect that Yahoo will give high returns with little variation.

In other words, each investor would perceive a different 'cloud' of investment opportunities. The edge of the cloud of investment opportunities, the IOC, would be different for every investor, in terms of both location and the investments in it.

Equally, lenders may charge a different rate of interest to every borrower, so that the location P would differ between individuals. They might also restrict credit to some (or all) investors, so that the length of the line between each investor's P would differ rather than being infinitely long, as Sharpe a.s.sumed. It might not even be a line, but could well be a curve, with lenders charging a higher rate of interest as borrowers committed themselves to more and more debt.

In other words, as with every neocla.s.sical theorem, Sharpe encountered an aggregation problem in going from the isolated individual to the level of society. And, like every neocla.s.sical economist, he took the time-honored approach of a.s.suming the problem away. He a.s.sumed (a) that all investors could borrow or lend as much as they liked at the same rate, and (b) that investors all agreed on the expected prospects for each and every investment.

Sharpe admitted that these were extreme a.s.sumptions, but he justified them by an appeal to the methodological authority of 'a.s.sumptions don't matter' Milton Friedman. In Sharpe's words: In order to derive conditions for equilibrium in the capital market we invoke two a.s.sumptions. First, we a.s.sume a common pure rate of interest, with all investors able to borrow or lend funds on equal terms. Second, we a.s.sume h.o.m.ogeneity of investor expectations: investors are a.s.sumed to agree on the prospects of various investments the expected values, standard deviations and correlation coefficients described in Part II. Needless to say, these are highly restrictive and undoubtedly unrealistic a.s.sumptions. However, since the proper test of a theory is not the realism of its a.s.sumptions but the acceptability of its implications, and since these a.s.sumptions imply equilibrium conditions which form a major part of cla.s.sical financial doctrine, it is far from clear that this formulation should be rejected especially in view of the dearth of alternative models leading to similar results. (Ibid.; emphasis added) Though Sharpe doesn't explicitly say this, he also a.s.sumes that investor expectations are accurate: that the returns investors expect firms to achieve will actually happen.

With these handy a.s.sumptions under his belt, the problem was greatly simplified. The riskless a.s.set was the same for all investors. The IOC was the same for all investors. Therefore all investors would want to invest in some combination of the riskless a.s.set and the same share portfolio. All that differed were investor riskreturn preferences.

Some would borrow money to move farther 'northeast' (towards a higher return with higher risk) than the point at which their indifference map was tangential to the IOC. Others would lend money to move 'southwest' from the point of tangency between their indifference map and the IOC, thus getting a lower return and a lower risk.

Since all investors will attempt to buy the same portfolio, and no investors will attempt to buy any other investment, the market mechanism kicks in. This one portfolio rises in price, while all other investments fall in price. This process of repricing investments alters their returns, and flattens the edge of the IOC.

11.5 Flattening the IOC The final step in Sharpe's argument relates the return on any single share to the overall market return, with a relation known these days as the share's 'beta.'13 What this means in practice is that the efficient markets hypothesis a.s.serts that the more volatile a share's returns are, the higher will be its expected yield. There is a trade-off between risk and return.

Sharpe's paper formed the core of the EMH. Others added ancillary elements such as the argument that how a firm is internally financed has no impact on its value, that dividends are irrelevant to a share's value, and so on. If this set of theories were correct, then the propositions cited earlier would be true: the collective expectations of investors will be an accurate prediction of the future prospects of companies; share prices will fully reflect all information pertinent to the future prospects of traded companies.14 Changes in share prices will be entirely due to changes in information relevant to future prospects; and prices will 'follow a random walk,' so that past movements in prices give no information about what future movements will be.

Reservations The outline above covers the theory as it is usually presented to undergraduates (and victims of MBA programs), and as it was believed by its adherents among stockbrokers and speculators (of whom there are now almost none). But Sharpe was aware that it was unsatisfactory, mainly because of side effects from the a.s.sumptions that investors are in complete agreement about the future prospects of traded companies, and that all investors can borrow or lend as much as they want at the riskless rate of interest.

One obvious side effect of the first a.s.sumption is that, once equilibrium is reached, trade on the stock exchange should cease. Thereafter, any trading should merely be the result of the random arrival of new information, or the temporary disturbance of equilibrium via the floating of some new security. The trading profile of the stock market should therefore be like that of an almost extinct volcano.

Instead, even back in the 1960s when this paper was written, the stock market behaved like a very active volcano in terms of both price volatility and the volume of trades. It has become even more so since, and in 1987 it did a reasonable, though short-lived, impression of Krakatoa.

The second a.s.sumption implies that anyone could borrow sufficient money to purchase all the shares in, say, Microsoft, and pay no more than the riskless rate of interest to do it. This implies a degree of liquidity that is simply impossible in the real world.

Sharpe very honestly discussed both the reality of these a.s.sumptions, and the implications of dropping them. He readily conceded that 'even the most casual empiricism' suggests that the a.s.sumption of complete agreement is false: 'People often hold pa.s.sionately to beliefs that are far from universal. The seller of a share of IBM stock may be convinced that it is worth considerably less than the sales price. The buyer may be convinced that it is worth considerably more' (Sharpe 1970). If this a.s.sumption is dropped, then in place of the single 'security market line,' and a spectrum of efficient investments which is the same for all investors, there is a different security market line for each investor. The clean simplicity of the EMH collapses.

The a.s.sumption that we can all borrow (or lend) as much as we like at the riskless rate of interest is just as unrealistic as the a.s.sumption that all investors agree. Sharpe concedes that the theory collapses once one accepts the reality that the borrowing rate normally exceeds the lending rate, that investors are credit rationed, and that the borrowing rate tends to rise as the amount being borrowed increases: The consequence of accommodating such aspects of reality are likely to be disastrous in terms of the usefulness of the resulting theory [...] The capital market line no longer exists. Instead, there is a capital market curve linear over some ranges, perhaps, but becoming flatter as [risk] increases over other ranges. Moreover, there is no single optimal combination of risky securities; the preferred combination depends upon the investors' preferences [...] The demise of the capital market line is followed immediately by that of the security market line. The theory is in a shambles. (Ibid.) But in the end, faced with a choice between an unrealistic theory and no theory at all, Sharpe opts for theory. His comfort in this choice continues to be Milton Friedman's methodological escape route that the unrealism of a.s.sumptions 'is not important in itself. More relevant, the implications are not wildly inconsistent with observed behavior' (ibid.).

But as discussed in Chapter 9, this argument that a.s.sumptions don't matter is valid only if they are negligibility a.s.sumptions (which dismiss features of the real world which are irrelevant or immaterial to the system being modeled) or heuristic a.s.sumptions (which are used to simplify argument en route to a more general theory, where the a.s.sumptions are dropped).

Do Sharpe's a.s.sumptions qualify under either of those headings? Clearly not. They are not negligibility a.s.sumptions if they were, then dropping them would not leave the theory 'in a shambles.' They are not heuristic a.s.sumptions since, as Sharpe concedes, once they are dropped the theory collapses, and he had no alternative to offer.

Instead, they are domain a.s.sumptions (factors that are required to make the theory valid, and in the absence of which the theory is invalid), and therefore the theory is valid only in a world in which those a.s.sumptions apply.

That is clearly not our world. The EMH cannot apply in a world in which investors differ in their expectations, in which the future is uncertain, and in which borrowing is rationed. It should have been taken seriously only had Sharpe or its other developers succeeded in using it as a stepping stone to a theory which took account of uncertainty, diverse expectations, and credit rationing. Since they did not do so, the EMH should never have been given any credibility yet instead it became an article of faith for academics in finance, and a common belief in the commercial world of finance.

Sharpe deserves commendation for honestly discussing the impact on his theory of relaxing his a.s.sumptions unfortunately, the same can't be said for the textbook writers who promulgated his views. However, the problems he saw with his theory are just the tip of the iceberg. There are so many others that it is difficult to think of a theory that could less accurately describe how stock markets behave.

Efficient or prophetic market? Figure 11.6 ill.u.s.trates the process which the EMH alleges investors use to determine the value of capital a.s.sets. Investors objectively consider information about the investment opportunities offered by different companies, and data about world economic prospects. Information that affects the future prospects of investments arrives randomly, generating random movements in the expected future prospects of firms. Investors' rational appraisal of this information leads to an efficient valuation of shares on the basis of expected return and risk, with price variations being caused by the random arrival of new information pertinent to share prices.

11.6 How the EMH imagines that investors behave This is a one-way process: there is no feedback from share market valuations to investor perceptions, and most importantly, investors are uninterested in what other investors are doing. This, of course, follows naturally from the a.s.sumption that all investors agree about the valuations of all companies: why bother checking what your neighbor thinks when you know he thinks exactly what you do (and any difference between his behavior and yours simply reflects his different riskreturn preferences)?

To put it mildly, there are serious problems with this theory of stock market behavior. For starters, the EMH makes no distinction between investors' expectations of the future and the future which actually occurs. In essence, the EMH presumes that investors' expectations will be fulfilled: that returns will actually turn out to be what investors expected them to be. In effect, every stock market investor is a.s.sumed to be Nostradamus. What economists describe as 'efficient' actually requires that investors be prophetic.

As soon as you allow that investors can disagree, then this economic notion of 'efficient expectations' also collapses. If investors disagree about the future prospects of companies, then inevitably the future is not going to turn out as most or perhaps even any investors expect.

This divergence between expectations and outcomes will set up disequilibrium dynamics in the stock market precisely the sort of behavior that the EMH cannot model, because it is above all a theory of market equilibrium. If investors influence each other's expectations, this is likely to lead to periods when the market is dominated by pessimistic and optimistic sentiment, and there will be cycles in the market as it shifts from one dominant sentiment to the other.

The efficient markets hypothesis was used to berate market partic.i.p.ants for believing that such phenomena as 'bull' and 'bear' markets actually existed: there was always only the efficient market. But even a slight concession to reality indicates that bull and bear phases will be part and parcel of a real-world stock market.

Risks ain't risks Sharpe's measure of risk was standard deviation, a statistical measure of how much the values thrown up by some process vary. If values are fairly evenly distributed around an average, then roughly two-thirds of all outcomes will be one standard deviation either side of the average.

For example, tests of IQ often have an average of 100 and a standard deviation of 16. This means that two-thirds of the population will score between 84 and 116 on an IQ test.

There are at least two problems with applying this concept to investment: Is variability really what an investor means by risk?

To actually work out a standard deviation, you need some process that has thrown up lots of historical data with a pattern which can be expected to continue recurring in the future.

Consider two investments: Steady has an average return of 3 percent, and a standard deviation of 3 percent; Shaky has an average return of 9 percent, and a standard deviation of 6 percent. Which one is 'riskier'?

According to Sharpe's criterion, Shaky is riskier: its standard deviation is twice as big as Steady's. However, according to any sane investor, Steady would be riskier since there's a much higher chance of getting a negative return from Steady than there is from Shaky. In other words, what an investor really worries about is not so much variability as downside risk. Standard deviation is a very poor proxy for this, even if a standard deviation can be meaningfully calculated in the first place.

This brings us to the second problem. Standard deviation can be used as a measure of variability for things such as the expected outcome of a dice roll, the age at which someone will die, even a golfer's possible scores. However, even here there are differences in how reliable a guide historical averages and standard deviations can be to future outcomes. So long as the dice are well designed, a roll is going to have a one in six chance of turning up a 2 for a considerable time until, for example, repeated rolls erode its edges. The historical averages for death, however, have changed dramatically in the West even during one lifetime, and major changes (for better or worse, depending on whether genetic engineering or global ecological problems come out on top during the twenty-first century) can be expected in the future. And if an eighteen-year-old golfer had an average of 70 and a standard deviation of 5 now, would you rely on those numbers as a guide to his performance in thirty years' time?

In other words, for measures like standard deviation to be reliable, past outcomes must remain a reliable guide to future outcomes. This is not going to be the case for an investment, because the future performance of a company depends upon future economic circ.u.mstances, future inventions, the actions of future compet.i.tors, all things to which the past provides no reliable guide beyond a very short time horizon. Investment, and stock market speculation, are, in other words, subject not to risk, but to uncertainty.

We have already discussed the implications of uncertainty for economic a.n.a.lysis. For stock market investors, uncertainty means that the expected yield of an investment over the medium- to long-term future simply can't be known: Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London, amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behavior does not govern the market. (Keynes 1936) Uncertainty, not risk, is the main factor standing between investors and an accurate knowledge of the future prospects of companies. As a result, the expected yield of an investment, the other variable in the EMH model of investor behavior, simply can't be known.

'The dark forces of time and ignorance ...' The efficient markets hypothesis argues that investors try to maximize their utility, where the only determinants of that utility are expected returns on the one hand, and risk on the other.

This kind of a.n.a.lysis has been soundly applied to interpret gambling. A gambler playing a game of blackjack faces known payoffs, and the known probabilities of drawing any given card. A good gambler is someone who intelligently applies these well-known regularities to decide how much to bet, when to hold, and when to risk another flip of the card.

This is an invalid concept to apply to an investor's behavior, since the game played in the casino of the stock market is subject to uncertainty, not risk.

Nonetheless, investors still need to form some expectations of the future if they are going to act at all. These will be based partly on factors they currently know such as prevailing economic conditions and partly on factors they can't know. In practice, they rely mainly upon the knowable factors simply because they are knowable: investors therefore extrapolate current trends into the indefinite future. As Keynes puts it: It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change. (Ibid.) This is clearly an unreliable practice, but in an uncertain world there is simply no other way to act. It is something that we must do in order not to be paralyzed into inaction, but it is something that, at a deep level, we are aware is untrustworthy. As a result, our forecasts of the future are tempered by an additional factor, the degree of confidence we have that these forecasts will be at least approximately correct. The more significant the degree of change expected, the more fragile that confidence will be.

The share market's valuations therefore reflect both collective forecasts, and the confidence with which these forecasts are made. In tranquil times these valuations will be relatively stable, but [i]n abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to antic.i.p.ate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation. (Ibid.) Therefore, in this uncertain world, the stock market will be ruled not by dispa.s.sionate a.n.a.lysis, but by euphoria, fear, uncertainty and doubt. It will be a place, not of a.n.a.lytic rationality, but of emotion.

The madness of the third degree Keynes once described himself as a speculator who had lost two fortunes and made three. His a.s.sessment of the behavior of stock market speculators was thus that of a well-informed insider. Keynes described the stock market as a game of 'Musical Chairs [...] a pastime in which he is victor [...] who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that [...] when the music stops some of the players will find themselves unseated' (ibid.).

The essence of this game is not to work out what particular shares are likely to be worth, but to work out what the majority of other players are likely to think the market will think they are worth, since 'it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence' (ibid.). In one of the most evocative a.n.a.logies ever used by an economist, Keynes compared investing in shares to those newspaper compet.i.tions in which the compet.i.tors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the compet.i.tor whose choice most nearly corresponds to the average preferences of the compet.i.tors as a whole; so that each compet.i.tor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other compet.i.tors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to antic.i.p.ating what average opinion expects the average opinion to be. (Ibid.) Though this may seem to be a description of the behavior of amateur investors in Internet chat rooms, Keynes insists that it is also the modus operandi of professional stock managers. First, because the future is uncertain, the kind of long-term forecasting which the EMH a.s.sumes is the norm is effectively impossible. It is far easier to antic.i.p.ate 'changes in the conventional basis of valuation a short time ahead of the general public' (ibid.).

Secondly, the boards that employ such professional stock managers discipline their behavior to make them conform to the norm. Any manager who is truly trying to antic.i.p.ate future economic trends is bound to make recommendations that are wildly at variance with what is popular in the market, and this behavior will appear eccentric and ill informed in comparison to the current market favorites. Imagine, for example, what would have happened to a funds manager who in mid-2000 advised the fund to sell all its shares in Yahoo, or Amazon, and spend the proceeds buying, for example, bonds.

As Keynes eloquently put it, 'Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.' Unconventional managers are thus weeded out, leaving behind only those who swim with the crowd.

Thirdly, the long-term investor has to ignore the prospect of quick short-term capital gains, and this runs counter to human nature's desire for quick results.

Finally, a long-term investor can't afford to be highly geared, since the results of being wrong will be expensive and the acc.u.mulated financing cost over the long run will be great. Speculators, on the other hand, are attracted to gearing by the allure of large immediate gains now, at a cost of only minor short-term interest charges (especially when the prevailing aura of confidence during a bull market leads them to discount the possibility of large losses).

11.7 How speculators actually behave Thus, according to Keynes, rather than looking dispa.s.sionately at investment prospects and world economic conditions, the main thing share market investors do is look furtively and emotionally at each other, to attempt to predict how the majority will value particular companies in the immediate future.

This behavior is pictured in Figure 11.7. Though investors do still keep an eye on individual investments and world conditions, and the world does throw in surprising events from time to time, in the main investors a.n.a.lyze the investment community itself.

As a result, there is a feedback from current share valuations to investors' behavior via the impact that present valuations have on investor expectations. A rising market will tend to encourage investors to believe that the market will continue rising; a falling market will maintain the sentiment of the bears. Such a market can find itself a long way from equilibrium as self-reinforcing waves of sentiment sweep through investors. These waves can just as easily break though long after any rational calculation might suggest that they should when it becomes clear that the wave has carried valuations far past a level which is sustainable by corporate earnings.

Addendum: Fama overboard Eugene Fama and his collaborator Kenneth French played a key role in promoting the efficient markets hypothesis, right from Fama's first major paper while still a PhD student, in which he stated that: 'For the purposes of most investors the efficient markets model seems a good first (and second) approximation to reality. In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is spa.r.s.e' (Fama 1970: 416).

Since then, Fama has become almost synonymous with the efficient markets hypothesis he, rather than Sharpe, is the author referred to as the originator of the hypothesis in most textbooks on finance. So it's rather significant that, in a major survey article published in 2004, he and French effectively disowned the theory: The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor poor enough to invalidate the way it is used in applications. The CAPM's empirical problems may reflect theoretical failings, the result of many simplifying a.s.sumptions [...]

In the end, we argue that whether the model's problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid. (Fama and French 2004: 25; emphasis added) Their reasons for reaching this conclusion mirror many of the points covered in Chapter 15 on the alternative 'Fractal Markets Hypothesis' and 'Inefficient Markets Hypothesis' (which I wrote in 2000, four years before Fama and French's paper was published): empirical research shows that the actual behavior of the market strongly contradicts the predictions of the EMH. Specifically: share market returns are not at all related to the so-called 'betas'; much higher returns and lower volatility can be gained by selecting undervalued stocks (ones whose share market value is substantially below their book value); and far from there being a trade-off between risk and return, it is possible to select a portfolio that has both high return and low volatility, by avoiding the so-called 'growth stocks' that are popular with market partic.i.p.ants.

In considering why the data so strongly contradicted the theory, Fama admitted two points that I labored to make in this chapter: that the theory a.s.sumes that all agents have the same expectations about the future and that those expectations are correct. Though they put this in a very awkward way, this is unmistakably what they said in this paragraph: Sharpe (1964) and Lintner [...] add two key a.s.sumptions to the Markowitz model to identify a portfolio that must be mean-variance-efficient. The first a.s.sumption is complete agreement: given market clearing a.s.set prices at t-1, investors agree on the joint distribution of a.s.set returns from t-1 to t. And this distribution is the true one that is, it is the distribution from which the returns we use to test the model are drawn. (Ibid.: 26; emphasis added) A whole generation of economists has thus been taught a theory about finance that a.s.sumes that people can predict the future without that being admitted in the textbook treatments to which they have been exposed, where instead euphemisms such as 'investors make use of all available information' hide the absurd a.s.sumptions at the core of the theory.

So wrong it's almost right The critiques above raise one curious question: how could a theory which was so obviously wrong nonetheless generate predictions about stock market behavior that, at a superficial level, looked roughly right?

One of the key predictions of the EMH is that 'you can't beat the market': in a perfect capital market, price fluctuations simply reflect the random arrival of new information, and yesterday's price trends are as relevant to tomorrow's as the last roll of the dice is to the next.

On the other hand, if the market is as 'imperfect' as argued above, and trends therefore exist, surely it should be possible for the intelligent investor to profit from these trends? If so, wouldn't this eventually lead to all opportunities for profit being sought out, thus removing the trends and, hey presto, making the market efficient? Not necessarily, for two reasons: a factor discussed briefly in Chapter 8: 'chaos,' and the inst.i.tutional structure of the market, which Keynes detailed in the General Theory.

We'll consider these issues in detail in Chapters 1314, when I finally leave behind the surreal world of neocla.s.sical economics and consider alternative theories that actually try to be realistic about how a complex monetary economy operates. But first, we have to consider the ultimate denouement of neocla.s.sical economics: its utter failure to antic.i.p.ate the biggest economic event since the Great Depression.

As this and the previous chapter have pointed out, neocla.s.sical economists of the 1920s also failed to see the Great Depression coming, so their failure to antic.i.p.ate this crisis was par for the course. Then, their failure led to the temporary overthrow of neocla.s.sical economics by Keynes, but as detailed in Chapter 10, neocla.s.sical economists led a successful counter-revolution that not only eliminated Keynes's ideas from economics, but also set Keynes up to be blamed for this crisis since the most prominent neocla.s.sical economists of the early twenty-first century called themselves 'New Keynesians.'

In the 1920s, the most prominent neocla.s.sical economist was Irving Fisher, and his failure to see the crisis coming destroyed his public reputation.15 But though Fisher could be criticized for not foreseeing the Great Depression, he could not be blamed for causing it. He was, after all, merely an observer.

This time round, the most prominent neocla.s.sical was Milton Friedman's acolyte Ben Bernanke. Whereas Fisher had merely been an observer, when the Great Recession hit, Bernanke was chairman of the organization charged with ensuring that such calamities don't happen: the Federal Reserve. And he had gotten the job because neocla.s.sical economists believed that, out of all of them, he knew best why the Great Depression occurred, and he was therefore the best man to make sure that 'It' could never happen again.

How wrong they were.

12 | MISUNDERSTANDING THE GREAT DEPRESSION AND THE GREAT RECESSION.

Bernanke's Essays on the Great Depression (Bernanke 2000) is near the top of my stack of books that indicate how poorly neocla.s.sical economists understand capitalism. Most of the others are books of pure theory, such as Debreu's Theory of Value (Debreu 1959), or textbooks like Varian's Microeconomic a.n.a.lysis (Varian 1992). Bernanke's distinguished itself by being empirical: he was, he claimed, searching the data to locate the causes of the Great Depression, since: To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also to an extent that is not always fully appreciated the experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge. (Bernanke 2000: 5) However, what Bernanke was actually doing was searching for an explanation that was consistent with neocla.s.sical theory. Statements to this effect abound throughout the Essays, and they highlight the profound difficulty he faced since according to neocla.s.sical theory, events like the Great Depression should not occur. This disconnection between reality and neocla.s.sical theory had at least the following manifestations that Bernanke admitted to in his Essays: Monetary variables affect inflation, but are not supposed to affect real variables money is supposed to be 'neutral': Of course, the conclusion that monetary shocks were an important source of the Depression raises a central question in macroeconomics, which is why nominal shocks should have real effects (p. 7) the gold standard theory leaves unsolved the corresponding 'aggregate supply puzzle,' namely, why were the observed worldwide declines in nominal aggregate demand a.s.sociated with such deep and persistent contractions in real output and employment? Or, in the language of contemporary macroeconomics, how can we explain what appears to be a ma.s.sive and very long-lived instance of monetary nonneutrality? (p. 277) A prolonged macro downturn is inconsistent with rational micro behavior: my theory [...] does have the virtues that, first, it seems capable of explaining the unusual length and depth of the Depression; and, second, it can do this without a.s.suming markedly irrational behavior by private economic agents. Since the reconciliation of the obvious inefficiency of the Depression with the postulate of rational private behavior remains a leading unsolved puzzle of macroeconomics, these two virtues alone provide motivation for serious consideration of this theory (p. 42; emphasis added) Rational behavior by agents should lead to all prices including money wages adjusting rapidly to a monetary shock, so that its impact should be transient: slow nominal-wage adjustment (in the face of ma.s.sive unemployment) is especially difficult to reconcile with the postulate of economic rationality. We cannot claim to understand the Depression until we can provide a rationale for this paradoxical behavior of wages (p. 7) Rapid adjustment of prices should bring the economy back to equilibrium: the failure of nominal wages (and, similarly, prices) to adjust seems inconsistent with the postulate of economic rationality (p. 32; emphasis added) Bernanke began well when he stated that the causes of the Great Depression had to lie in a collapse in aggregate demand though even here he manifested a neocla.s.sical bias of expecting capitalism to rapidly return to equilibrium after any disturbance: Because the Depression was characterized by sharp declines in both output and prices, the premise of this essay is that declines in aggregate demand were the dominant factor in the onset of the Depression.

This starting point leads naturally to two questions: First, what caused the worldwide collapse in aggregate demand in the late 1920s and early 1930s (the 'aggregate demand puzzle')? Second, why did the Depression last so long? In particular, why didn't the 'normal' stabilizing mechanisms of the economy, such as the adjustment of wages and prices to changes in demand, limit the real economic impact of the fall in aggregate demand (the 'aggregate supply puzzle'). (Ibid.: ix) However, from this point on, his neocla.s.sical priors excluded both salient data and rival intellectual perspectives on the data. His treatment of Hyman Minsky's 'Financial Instability Hypothesis' which is outlined in Chapter 13 is particularly reprehensible. In the entire volume, there is a single, utterly dismissive reference to Minsky: Hyman Minsky (1977) and Charles Kindleberger [...] have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the a.s.sumption of rational economic behavior. [A footnote adds:] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go. (Ibid.: 43) As we shall see, this is a parody of Minsky's hypothesis. He devoted slightly more s.p.a.ce to Irving Fisher and his debt-deflation theory, but what he presented was likewise a parody of Fisher's views, rather than a serious consideration of them: The idea of debt-deflation goes back to Irving Fisher (1933). Fisher envisioned a dynamic process in which falling a.s.set and commodity prices created pressure on nominal debtors, forcing them into distress sales of a.s.sets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed.

Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects [...] (Ibid.: 24)1 There are many grounds on which this is a misrepresentation of Fisher,2 but the key fallacy is the proposition that debt has no macroeconomic effects. From Bernanke's neocla.s.sical perspective, debt merely involves the transfer of spending power from the saver to the borrower, while deflation merely increases the amount transferred, in debt servicing and repayment, from the borrower back to the saver. Therefore, unless borrowers and savers have very different propensities to consume, this transfer should have no impact on aggregate demand.

The contrast with the theoretical case that Marx, Schumpeter, Keynes and Minsky made about debt and aggregate demand could not be more stark and in the next chapter I'll make the empirical case that a collapse in debt-financed demand was the cause of both the Great Depression and the Great Recession. Bernanke's neocla.s.sical goggles rendered him incapable of comprehending the best explanations of the Great Depression, and led him to ignore the one data set that overwhelmingly explained the fall in aggregate demand and the collapse in employment.

The three reasons he ultimately provided for the Great Depression were (a) that it was caused by the then Federal Reserve's mismanagement of the money supply between 1928 and 1931; (b) that the slow adjustment of money wages to the fall in aggregate demand is what made it last so long; and (c) that the gold standard transmitted the collapse internationally. His conclusion on the first point was emphatic: 'there is now overwhelming evidence that the main factor depressing aggregate demand was a worldwide contraction in world money supplies. This monetary collapse was itself the result of a poorly managed and technically flawed international monetary system (the gold standard, as reconst.i.tuted after World War I)' (ibid.: ix).

He was also emphatic about his 'smoking gun': the Great Depression was triggered by the Federal Reserve's reduction of the US base money supply between June 1928 and June 1931: The monetary data for the United States are quite remarkable, and tend to underscore the stinging critique of the Fed's policy choices by Friedman and Schwartz [...] the United States is the only country in which the discretionary component of policy was arguably significantly destabilizing [...] the ratio of monetary base to international reserves [...] fell consistently in the United States from [...] 1928:II [...] through the second quarter of 1931. As a result, U.S. nominal money growth was precisely zero between 1928:IV and 1929:IV, despite both gold inflows and an increase in the money multiplier.

The year 1930 was even worse in this respect: between 1929:IV and 1930:IV, nominal money in the United States fell by almost 6 [percent], even as the U.S. gold stock increased by 8 [percent] over the same period. The proximate cause of this decline in M1 was continued contraction in the ratio of base to reserves, which reinforced rather than offset declines in the money multiplier. This tightening seems clearly inconsistent with the gold standard's 'rules of the game,' and locates much of the blame for the early (pre-1931) slowdown in world monetary aggregates with the Federal Reserve. (Ibid.: 153) There are four problems with Bernanke's argument, in addition to the fundamental one of ignoring the role of debt in macroeconomics. First, as far as smoking guns go, this is a pop-gun, not a Colt .45. Secondly, it has fired at other times since World War II (once in nominal terms, and many times when adjusted for inflation) without causing anything remotely like the Great Depression. Thirdly, a close look at the data shows that the correlations between changes in the rate of growth of the money supply3 and unemployment conflict with Bernanke's argument that mismanagement of the monetary base was the causa causans of the Great Depression. Fourthly, the only other time that it has led to a Great Depression-like event was when Bernanke himself was chairman of the Federal Reserve.

Between March 1928 and May 1929, base money fell at an average rate of just over 1 percent per annum in nominal terms, and a maximum rate of minus 1.8 percent.4 It fell at the same rate between 1948 and 1950, and coincided with a garden-variety recession, rather than a prolonged slump: unemployment peaked at 7.9 percent and rapidly returned to boom levels of under 3 percent. So the pop-gun has fired twice in nominal terms, and only once did it 'cause' a Great Depression.

It could also be argued, from a neocla.s.sical perspective, that the Fed's reduction in base money in the lead-up to the Great Depression was merely a response to the rate of inflation, which had turned negative in mid-1924. Neocla.s.sical theory emphasizes money's role as a means to facilitate transactions, and a falling price level implies a need for less money. On this point Milton Friedman, whom Bernanke cited as a critic of the Federal Reserve for letting base money fall by 1 percent per annum, argued elsewhere that social welfare would be maximized if the money supply actually fell by 10 percent per year.5 12.1 Inflation and base money in the 1920s When the inflation-adjusted rate of change of base money is considered, there were numerous other periods when base money fell as fast as in 1928/29, without leading to a depression-scale event. The average inflation-adjusted rate of growth of M0 in mid-1928 to mid-1929 was minus 0.5 percent, and even in 1930 M0 fell by a maximum of 2.2 percent per annum in real terms. There were six occasions in the post-World War II period when the real rate of decline of M0 was greater than this without causing a depression-like event6 (though there were recessions on all but one occasion). Why did the pop-gun fire then, but emit no smoke?

The reason is, of course, that the pop-gun wasn't really the guilty culprit in the crime of the Great Depression, and Friedman and Bernanke's focus upon it merely diverted attention from the real culprit in this investigation: the economy itself. Capitalism was on trial because of the Great Depression, and the verdict could well have been attempted suicide which is the last verdict that neocla.s.sical economists could stomach, because they are wedded to the belief that capitalism is inherently stable. They cannot bring themselves to consider the alternative perspective that capitalism is inherently unstable, and that the financial sector causes its most severe breakdowns.

To neocla.s.sicals like Friedman and Bernanke, it was better to blame one of the nurses for incompetence, than to admit that capitalism is a manic-depressive social system that periodically attempts to take its own life. It was better to blame the Fed for not administering its M0 medicine properly, than to admit that the financial system's proclivity to create too much debt causes capitalism's periodic breakdowns.

12.2 Inflation and base money in the post-war period It is therefore a delicious if socially painful irony that the only other time that the pop-gun fired and a depression-like event did follow was when the chairman of the Federal Reserve was one Ben S. Bernanke.

Bernanke began as chairman on 1 February 2006, and between October 2007 and July 2008, the change in M0 was an inflation-adjusted minus 3 percent one percent lower than its steepest rate of decline in 193033. The rate of change of M0 had trended down in nominal terms ever since 2002, when the Greenspan Fed had embarked on some quant.i.tative easing to stimulate the economy during the recession of 2001. Then, M0 growth had turned from minus 2 percent nominal (and minus 6 percent real) at the end of 2000 to plus 11 percent nominal (and 8 percent real) by July 2001. From there it fell steadily to 1 percent nominal and minus 3 percent real by the start of 2008.

12.3 Bernanke's ma.s.sive injection of base money in QE1 Whatever way you look at it, this makes a mockery of the conclusion to Bernanke's fawning speech at Milton Friedman's ninetieth birthday party in November 2002: 'Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again' (Bernanke 2002b).

Either Bernanke forgot what he learnt from Friedman and his own research once in office since Friedman and Bernanke's criticism of the 1920s Fed was that it let the growth rate of M0 drop too low before the crisis or the advice itself was irrelevant. The latter is of course the case. As I argue in the next chapter, the key to preventing depressions is to prevent an explosion in the ratio of private debt to GDP, so that debt-financed demand cannot reach a level from which its collapse will trigger a depression. Far from explaining what caused the Great Depression, Friedman and Bernanke's simplistic perspective diverted attention from the real culprit the expansion of private debt by the banking sector and ignored the enormous growth of debt that occurred while the central bank was under the thrall of neocla.s.sical economics.

12.4 Change in M0 and unemployment, 192040 The relative irrelevance of changes in base money as a cause of changes in unemployment, let alone a cause of serious economic breakdown, can be gauged by looking at the correlation between the growth of M0 and the rate of unemployment over the period from 1920 till 1940 across both the boom of the Roaring Twenties and the collapse of the Great Depression (see Figure 12.4). If too slow a rate of growth of M0 can trigger a depression, as Bernanke a.s.serts, then surely there should be a negative correlation between the change in M0 and the rate of unemployment: unemployment should fall when the rate of change of M0 is high, and rise when it is low.

The correlation has the right sign for the period from 1920 till 1930 (minus 0.22 for changes in nominal M0 and minus 0.19 after inflation) but the wrong one for the period from 1930 till 1940 (plus 0.28 for nominal M0 and 0.54 after inflation), and it is positive for the entire period 192040 (plus 0.44 for nominal change to M0, and 0.61 for the inflation-adjusted rate of change). Therefore unemployment increased when the rate of growth of M0 increased, and fell when it fell. Lagging the data on the basis that changes in M0 should precede changes in unemployment doesn't help either the correlation remains positive.

On the other hand, the correlation of changes in M1 to unemployment is negative as expected over both the whole period (minus 0.47 for nominal change and minus 0.21 for inflation-adjusted change) and the sub-periods of the Roaring Twenties (minus .31 for nominal M1 and 0.79 for inflation-adjusted) and the Great Depression (minus 0.62 for nominal and 0.31 for real). So any causal link relates more to private-bank-driven changes in M1 than to central-bank-driven changes in M0.