Shiller: More Expectations Theory, Less Efficient Market Hypothesis

Yale professor Bob Shiller’s column in the Sunday NYT ( The Sickness Beneath the Slump) is filled with interesting tidbits, data and analysis.

You may be tempted to think of his column as the typical Residential Real Estate analysis, looking at historical prices and current trends.


What the good professor does this morning is damn his own profession for their slavish devotion to bad theory. The Efficient Market Hypothesis — at least as  practiced by Wall Street economists — is the rough equivalent of a million monkeys with a million typewriters creating Hamlet. That somehow out of a crowd of emotional, irrational, ill-informed and greedy humans, some form of truth will emerge.


Professor Shiller mentions the “speculative bubble that generated pervasive optimism and complacency” as a lead in to his discussion. He describes the theoretical failings of economics:

“A half-century ago, there was a lively discussion among economists about the dynamics of price expectations. For example, Alain C. Enthoven, then of the Massachusetts Institute of Technology, and Kenneth J. Arrow of Stanford wrote in 1956 that expectations that extrapolate past price increases can produce economic instability. But that thinking was largely cast aside in the 1960s, when my profession embraced the theory that efficient markets formed by people holding rational expectations could explain virtually all economic activity.

As a result, economists in recent decades have not developed expectations theory much further. That needs to be corrected in coming years. In the meantime, this failing helps explain why the current crisis was generally unpredicted, and why its future course is so poorly understood.”

Bob is far too diplomatic to be blunt, so I will do it for him: Economics failed. The entire profession took a theory that had some value to it, and extrapolated it to the point of magical thinking.

How badly did the economics profession, academics and market pros alike, fail? Classic economic belief systems could not appropriately anticipate in advance or even identify in real time what was happening with the Residential RE/Housing market. They failed to see the Great Recession coming or even the market collapse.

The basis for this failure was the erroneous belief that “efficient markets formed by people holding rational expectations could explain virtually all economic activity.”

That thesis has now been thoroughly discredited. It is still taught in colleges and business schools, which is why I find most MBAs not worth hiring. Frequently, they can be worse than clueless — they are steeped in the bad ideas of long dead economists, and in my profession, that is not a formula for making money.

As history has revealed over and over again, the popular extreme version of EMH is bollocks. Markets can and do generate lots and lots of useful information and price discovery. But their strength derives from the inputs of the crowd. That strength is also their weakness when that crowd turns into a panicky mob.


Efficient Market Hypothesis

The Sickness Beneath the Slump
NYT, June 11, 2011

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