Bookblogging: Failure of the EMH

by John Quiggin on August 1, 2009

Another section from the forthcoming book. Casting suggestions for the blockbuster movie will be gratefully accepted, along with more prosaic correction of errors, omissions, and of course, compliments. I’m trying to get a nice HTML version, but will see how it goes


As with the other doctrines discussed in this book, the failure of the EMH is not a sudden shock arising from the Global Financial Crisis. The evidence for the strong forms of the EMH was never particularly convincing. Rather, it was an idea that suited both the demands of the times and the intellectual tendencies that were dominant within the economics profession.

During the 1970s and 1980s, assessment of the EMH was largely confined to econometric studies. The process of financial deregulation, beginning with the breakdown of the Bretton Woods system in the early 1970s was a gradual one. It was only by the mid-1980s that most restrictions on international capital flows and exchange rate movements were completely removed. The end of domestic deregulation took even longer. So, it was not until the 1990s that failures of the global financial system could reasonably be regarded as evidence against the EMH.

That evidence was not long in coming. A number of developing countries experienced severe financial crises in the 1990s, even though their governments had done their best to follow the policy prescriptions of economic liberalism, in particular by deregulating financial markets and encouraging private investment. 

The experience of the US itself provided plenty of evidence against the EMH. The near-collapse and government-orchestrated rescue of hedge fund LTCM provided a preview of the massive bailouts of 2008 and 2009, undermining some key assumptions of the EMH in the process. Even more significantly, the boom and bust in the shares of ‘dotcom’ companies that promised to generate vast profits from the Internet showed that all the sophistication and complexity of modern financial markets only served to make possible bigger and better bubbles.

Sadly, these lessons went unlearned. Despite repeated failures to meet the test of experience, the EMH remained central to finance theory and to policy practice, right up to its final catastrophic collapse in the meltdown of 2008.

Econometric testing

Like many of the dead ideas discussed in the book, the efficient markets hypothesis was not particularly well supported by empirical evidence even in its heyday. The weak form of the hypothesis, was reasonably successful when subjected to the statistical tests applied by econometricians, but the strong and semi-strong forms much less so.

As was discussed above, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). Broadly speaking, this weak version of the EMH is consistent with the evidence. At least, there are no simple and reliable trading strategies that have been shown to beat the market consistently.

On the other hand, econometric studies given little support to the semi-strong and strong forms of the hypothesis.  Most importantly, as economists such as Robert Shiller has shown, the volatility of asset prices is much greater than is predicted by the EMH. That is, where the EMH suggests that financial markets provide a way of managing economic risk, the evidence suggests that they are actually a major source of such risk.

The behavior of currency markets after the breakdown of the Bretton Woods agreement provides a good example.  A large body of economic analysis shows that, in the long run, exchange rates must be somewhere close to Purchasing Power Parity, that is, the rate at which a US dollar can buy the same goods in the US as it can if converted into euros and spent in Europe 1 Advocates of floating exchange rates confidently expected that, whereas governments had frequently tried to maintain rates inconsistent with PPP, financial markets would bring exchange rates into line with underlying economic values, and thereby lead to greater long-term stability. In fact, the reverse has happened. In the decade since the creation of the euro, its value has been as low as 85 US cents and as high as $US1.50, even though price levels in both the EU and the US have been quite stable, and interest rates fairly comparable.Stock markets similarly display much more volatility than the EMH suggests is consistent with the observed variability of aggregate consumption. 

As with the closely related equity premium puzzle (see CH ..), it is easy enough to see that the standard theory underlying the EMH (and the closely associated capital asset pricing model). A recent survey by Stephen LeRoy of UCSB concluded 

no single convincing explanation has been provided for the volatility of equity prices. The conclusion that appears to follow from the equity premium and price volatility puzzles is that, for whatever reason, prices of financial assets do not behave as the theory of consumption-based asset pricing predicts.


1 For a number of reasons, including the fact that many services aren’t traded on international markets, this equality isn’t expected to hold exactly. But it should be close.

Emerging market financial crises

After the turmoil of the 1970s and 1980s, developed countries enjoyed a period of sustained economic expansion in the 1990s, with the United States leading the way. For a while, less developed countries (now relabelled as ‘emerging markets’ in the financial sector) enjoyed similarly smooth sailing. But from the mid-1990s onwards, there were a string of financial crises in Mexico, Argentina, Russia and most spectacularly, East and South-East Asia.

The developing-country financial crises of the 1980s had followed a pattern that supported an efficient markets hypothesis. Governments had borrowed heavily, spent the proceeds on military adventures or luxury projects, intervened to distort market prices, and attempted to restrict international capital flows. When they got into trouble, as they inevitably did, they were forced to call on the International Monetary Fund for help. 

Its standard prescriptions supported by the US Treasury and the World Bank were christened the ‘Washington Consensus’ by John Williamson of the Institute for International Economics. Williamson listed ten elements of the standard package, notably including financial deregulation and privatization of state enterprises. Although Williamson’s initial presentation included discussion of the need for appropriate prudential regulation of financial institutions, later versions of the Washington Consensus dropped this element, and incorporated more radical versions of economic liberalism, to the point that Williamson himself disavowed the phrase.

The crises of the mid-1990s hit countries that had, in general, embraced the policies of the Washington consensus. The pattern was the same in each case. Following financial deregulation, countries enjoyed strong capital inflows and booming stock markets. Some seemingly minor event produced a reversal in market sentiment and a sudden flight of capital, producing an economic crisis. Following the crisis, the IMF and world markets sought to impose the 1980s package of public expenditure cuts and economic contraction, which only exacerbated the problem. Finally, in retrospect, the victims were blamed for minor divergences from the free-market ideal which, before the crisis, had been seen as unimportant, or even praiseworthy.

 Asian economies had enjoyed decades of strong growth through policies of export-oriented industrialisation, rejecting the ‘import replacement’ policies, aimed at economic self-sufficiency that had been tried and failed elsewhere. From the early 1990s onwards, they had been engaged in a process of financial deregulation. Only a year before the crisis hit, the World Bank had produced a glowing report praising the ‘Asian economic miracle’ as an exemplar

The case of Argentina was even more striking. Rejecting the failed policies of the Peron era, Argentina had adopted the most extreme version of the Washington Consensus, privatising industry on a large scale, and even establishing a currency board to guarantee a fixed exchange rate with the US dollar. Yet when the economy ran into trouble, the financial markets were left to fend for themselves. 

The Asian financial crisis cast doubt on the idea that globalization was both inevitable and beneficent, as did the failure of Washington consensus policies in Argentina. Even more embarrassing was the success of Malaysia, which r imposed controls on the movements of foreign exchange, the cardinal sin against global financial markets. Unlike neighbors who followed the advice of the IMF, Malaysia was largely unaffected by the crisis.

Despite all this, the confidence of financial markets and policymakers in the Efficient Markets Hypothesis was unshaken. The Asian countries that had been seen, only a year earlier, as reflecting the fruits of reform were denounced as embodiments of ‘crony capitalism’. The conclusion drawn was that, only with a fully-developed, transparent and incorruptible financial system, like that of Wall Street or the City of London, could the benefits of financial markets be fully realised.

The LTCM fiasco

 The debate over the EMH gave rise to the view thatt the market is just close enough to perfect efficiency that the returns available from exploiting any inefficiency are equal to the cost of the skill and effort that goes into discovering it. This idea is central to the operations of hedge funds, which seek to discover strategies by which investors willing to take a risk can earn above average returns. However, it came spectacularly adrift in 1998, with a hedge fund called Long Term Capital Management, which employed as its expert advisers, none other than Robert Merton and Myron Scholes.

The strategy employed by LTCM was to discover small deviations from efficient market pricing, on which it could make bets that were sure to win. Instead of simply betting with its investors money, it used that money as equity for massive borrowings, which ensured that the payoff from its winning bets was multiplied many times over. Reliance on ‘leverage’ to multiply profits has been a characteristic of many financial bubbles, a point reflected in the saying “Genius is leverage in a rising market”. But it has never before operated on the scale seen in the Great Bubble, and exemplified by LTCM.

Thanks to the use of complex derivatives, LTCM turned an equity base of less than $5 billion into derivative positions with a notional value of approximately $1.25 trillion. These derivatives, such as interest rate swaps, were developed with the supposed goal of allowing firms to manage risk on exchange rates and interest rate movements. Instead, they allowed speculation on an unparalleled scale.

The particular focus of LTCM was what is called, in the picturesque jargon of the financial markets, the “yen carry trade”. The basis for the trade is the fact that, ever since Japan’s own bubble economy exploded in 1990, interest rates in Japan, and therefore any interest rates for debts denominated in Japanese yen, have been very low. Hence, money can be made by borrowing money in yen, “carrying” it to the US market, and lending it in US dollars. The catch is that if the dollar depreciates against the yen,

LTCM did not focus on the yen carry trade itself, but on the interest rate margins that drove the trade. It looked for divergences between the margins generated by the markets and the values predicted by its computer models, then bet that the market would ‘correct itself’ over time. These bets paid off for a number of years, making big profits for LTCM owners and investors. But, in 1997 with Asian financial crisis, all its bets failed at once.

The unregulated status of hedge funds had been justified on the basis that the investors were sophisticated and wealthy individuals, and that only their own money was at risk. But it soon turned out that the leveraged investments made by LTCM had been financed by huge loans from major Wall Street and international banks, and that a failure by LTCM ran the risk of generating a systemic collapse. The US Federal Reserve, under Chairman Alan Greenspan, orchestrated a rescue package, with major banks being pressured to contribute (among the Wall Street investment banks, Bear Stearns was the only one to refuse). The crisis was staved off, and the LTCM principals and investors escaped with much of the wealth gained from their earlier successful bets intact.

The LTCM episode had numerous lessons, many of which pointed out at the time but few of which were taken to heart by policymakers.

In retrospect, the strategy pursued by LTCM can be seen as a variant on the ancient ‘martingale’ betting strategy. As Slate writer Jordan Ellenberg explained in an excellent article last year, the strategy can be illustrated by betting on a coin 

Bet 100 bucks on heads. If you win, you walk away $100 richer. If you lose, no problem; on the next flip, bet $200 on heads, and if you win this time, take your $100 profit and quit. If you lose, you’re down $300 on the day; so you double down again and bet $400. The coin can’t come up tails forever! Eventually, you’ve got to win your $100 back.

The problem with the martingale is that you are trading off a steadily diminishing probability of losing against a steadily increasing loss if you do. At some point, there will be a run of tails long enough to bankrupt you.

What is true of the martingale is true of more sophisticated variants, like the strategies of LTCM. This point ought to have been evident from the LTCM failure. Instead, the conclusion drawn by both financial markets and regulators was that the problem could be solved by designing ever more complicated derivatives. By the time the whole thing blew up in 2007, the complex trades that had brought LTCM to grief looked like child’s play.

A second crucial point is that diversification of risks only works to a certain extent, and can be undermined by attempts to exploit it.Once the limits of diversification have been reached rearranging the set of claims involved isn’t going to reduce risk any further, so if all parties appear to be making risk-free profits, the risk must have been shifted to some low-probability, high-consequence event. 

LTCM relied in part on the assumption that currency markets were largely independent, so that losing bets made on one currency would, in general, be cancelled out by wins on others.

There were also lessons for regulators. The first was that no system of financial regulation can survive if some firms are guaranteed and regulated, but are allowed to deal on a large scale with others that are not regulated. The second is the old one of ‘moral hazard’: if people are protected by insurance from the bad consequences of risks, they will tend to take more risk as a result.

Financial market players ignored a ll these lessons, but they did learn one big one, which was the opposite of the moral hazard lesson ignored by regulators, namely, the existence of ‘Greenspan put’. A put is a kind of option allowing you to sell a stock at an agreed price on a given date. In effect, the holder of a put has a one-way bet on the stock they own. If it goes up, they sell the stock on the market and collect the profits. If it goes down, they exercise the put option and collect the agreed price.

Precisely because they are so attractive, put options are valuable ( the Black-Scholes rule shows how to value them). What was special about the Greenspan put was that it was free. The LTCM precedent showed that, if financial markets ever got into really serious trouble, the Federal Reserve would bail them out. So, any kind of risk taking behavior became a one-way bet, as long as sufficiently many of the big financial institutions were making the same bet. 

The first exercise of the Greenspan put came in the wake of the dotcom crash, discussed in the next section. The second, and much bigger one came in October 2008, at the hands of Greenspan’s successor, Ben Bernanke. This time, though, not even a trillion dollar bailout was enough to save all the big financial institutions from the consequences of their reckless speculation.

The dotcom bubble

Stock markets in the US and elsewhere rose strongly in the 1980s and 1990s, interrupted only briefly by the crash of October 1987 (which, in retrospect, fostered the illusion that any decline in stock prices would be quickly reversed). By 1996, the boom had reached the point where, with the Dow Jones index at 8000, Alan Greenspan warned of the dangers of ‘irrational exuberance’ in asset markets. Greenspan never repeated the warning, and soon returned to his customary role a cheerleader for speculative markets. However, the catchphrase was adopted by economist Robert Shiller as the title of a penetrating analysis of the role of self-deception and collective over-optimism in stock market bubbles

The bubbles had raised stock prices in general, but it was propelled to new heights by the arrival of the ‘dotcom’ sectors. The Internet, developed as a public service by the US government research agency DARPA and by the university sector worldwide, was opened to commercial use in the 1990s, just as its most popular manifestation, the Worldwide Web was coming online. 

In 1995, the Mosaic web browser, created at the publicly-funded National Center for Supercomputing Applications, was converted into a commercial product named Netscape, which formed the basis of a spectacularly successful Initial Public Offering (IPO). The stock was set to be offered at $14 per share. But, a last-minute decision doubled the initial offering to $28 per share. The stock’s value soared to $75 on the first day of trading, nearly a record for first-day gain. 

Never profitable on an annual basis, Netscape was acquired by America Online (AOL) in a stock-swap valued at US$4.2 billion in 1998. A couple of years later, in the biggest merger in history, AOL merged with Time Warner. The deal gave AOL a market value of more than $100 billion; it is now valued at around $4 billion.

The Netscape IPO and AOL takeover set the pattern for a string of ever more dubious “dotcom” ventures, producing huge gains for investors despite the absence of significant profits, and in many cases, even revenues or products. The history of Netscape and AOL was mirrored by thousands of firms which attached the dotcom suffix to businesses as mundane as selling dogfood and garden supplies, or as spurious as that of the pioneering entrepreneur of the 1713 South Sea Bubble who sold shares in “a company for carrying out an undertaking of great advantage, but nobody to know what it is”. Indeed whereas Netscape and AOL had substantial revenues, and AOL had a profitable business as an Internet service provider, the typical dotcom never made a genuine sale, let alone a profit.

Speculation on dotcoms centred on the NASDAQ stock exchange. 1 The NASDAQ index rose from 800 in the mid-1990s, to over 5000 at its peak in March 2000 when it collapsed suddenly, falling below 2000 (as of May 2009, the index stood at 1700). Hundreds of dotcom companies failed or were taken over at prices far below those of the late 1990s. 

Even more than the complex global crisis now underway, the NASDAQ bubble and bust provided a sharp test of the efficient markets hypothesis, which failed egregiously.  It was obvious, and pointed out by many observers, that the prices being paid for dotcom investments could not be justified on the basis of standard principles of valuation. Even if some turned out to be the spectacular successes promised in their business plans, it was impossible that the sector as a whole could do so. (In reality, the only company created in this period that is earning large and growing profits as of 2009 is Google, and its shares were not traded until 2004).`

Previous bubbles might have been dismissed on the basis that the markets concerned weren’t fully informed and transparent, or that speculators were prevented from betting against the bubble assets and thereby bringing prices back to earth. The dotcom bubble showed that none of these defences worked.

As regards transparency, no market in history has been subject to such intense scrutiny and obsessive coverage as the NASDAQ of the late 1990s. Stocks and the companies that issued them were assessed by investment banks, stockbrokers and the financial press. The dubious projections on which they relied were set out in prospectuses which warned (in a pro forma fashion) that they might not be fulfilled.

Speculators did attempt to burst the bubble. Julian Robertson of Tiger Investments, short-sold grossly overvalued tech stocks in the late 1990s and lost billions when the stocks rose even further in 1999. He quit managing other people’s money, telling clients that he no longer understood the markets.

Although the dotcom bubble and bust was spectacular, the 2000-01 crash was at least equally significant for the exposure of corporate fraud on a scale unparallelled (at the time) since the 1920s.  The two biggest frauds, Enron and Worldcom offered a sharp contrast. The Enron frauds relied on a complex network of trading schemes, special purpose vehicles and elaborate accounting devices. By contrast, the managers of Worldcom simply invented revenue numbers that made the company look massively profitable when it was actually losing money hand over fist.


1 A competitor to the New York Stock Exchange that had been established by brokers including Bernard Madoff, who confessed in late 2008 to having operated the biggest Ponzi scheme in history

The crisis of 2008

The bursting of the dotcom bubble spelt, or should have spelt, the end of belief the strong forms of the efficient market hypothesis. On the other hand, by exposing weaknesses in the systems that were supposed to keep financial markets operating properly, it gave regulators and financial institutions a chance to clean up, so that future outcomes could be more like those predicted by theory.

Neither of these things happened. Advocates of the efficient markets hypothesis, in general, simply ignored the dotcom fiasco, and went on as if nothing had happened. The accounting scandals at Enron and other companies produced the Sarbanes-Oxley Act, which sought to reform corporate governance. But the Act was limited and largely ineffectual. Within a year or two, the conventional wisdom of the financial markets was that Sarbanes-Oxley was an over-reaction to isolated cases of fraud, and that a new push for deregulation was needed.

Financial institutions could disregard the failures of the dotcom bubble because of the (seemingly successful) operation of the Greenspan put. Rather than let the financial sector suffer the consequences of the bursting bubble, Greenspan relaxed monetary policy and inflated a whole new bubble, this time in housing.

The housing boom in the US was not spectacular by global standards. Its crucial characteristic was that both the boom and the subsequent bust took place in all major markets simultaneously.  As with the LTCM disaster a decade earlier, the models used by financial instruments to rate the riskiness of mortgages and assets derived from those mortgages incorporated the assumption that separate housing markets in the US were largely independent of each other. Hence, a diversified portfolio of US mortgages was highly unlikely to suffer losses on all or most of its holdings at once.

But the very transactions justified by the models undermined the assumptions on which they were based. The demand for diversified portfolios meant that lenders lowered their standards in all markets at once. Whereas previous US real estate booms had been based on local factors leading to optimism about the prospects for particular markets, the boom of the early 2000s was based on a general believe that real estate, as an asset, was bound to go up in value.

This assumption was embodied in the construction and pricing of an ever more complex range of financial derivatives. The process began with the observation that, if house prices kept on rising, the absence of a downpayment was not a problem, since the borrower’s equity would rise with the price of the house. That in turn meant that it would be possible to refinance a loan on more favorable terms. 

Hence, on this assumption, it made sense to offer ‘negative-amortisation’ loans, in which, for an initial period of two or three years, the borrower did not pay down the debt at all, but added to it. After the initial ‘honeymoon’ period, these loans were set to revert to much more stringent terms, but it was convenient for everyone to assume that, when the time came, the loan could be refinanced.

Based on these assumptions, investment banks were prepared to buy securities based on loans made by mortgage lenders such as Countrywide. The resulting loss of market share by Fannie Mae and Freddie Mac led these institution to lower their standards. Beginning in 2004, they entered the subprime market on a large scale, relying on their implicit guarantee to hold down borrowing costs. Increasingly competitive securitisation also reduced the incentive of the original lenders to monitor the creditworthiness of borrowers; once they had packaged the mortgages into securities they were no longer exposed to the risk of default, and the demand for securities was so strong that quality was not a major problem.

The growth in demand for mortgage-backed securities reflected a range of innovations, such as the rise of bond guarantors, and the development of collateralized debt obligations (CDOs) under which a portfolio of mortgage-backed securities was transformed into a set of assets some of which were supposed to pay off even in the event of a downturn in local housing markets (the possibility of a national downturn was excluded from consideration in the models used to rate these securities). 

These and other devices, combined with optimistic assumptions about default and repayment rate, made it appear that the risks associated with lending could be made to vanish. With the blessing of ratings agencies such as Moody’s and Standard & Poors, loans to people who might have neither a regular income, nor a job, nor any  asset except the house itself (the acryonym NINJA (no income, no job or assets) was used to describe them) were transformed into ‘super-senior’ bonds given the same AAA credit rating accorded to the US government itself.

By late 2006, loans to borrowers with weak or non-existent credit formed the basis of an inverted pyramid amounting to trillions of dollars of spurious assets created by banks and hedge funds around the world. Some of these institutions were explicitly backed by national governments. Many others were ‘too big to fail’; given the complex and fragile web of financial transactions built up since the 1970s, the breakdown of even a medium-sized player could bring the whole system to a halt.

The stage was set for a global economic meltdown. The crisis built up slowly over the course of 2007, as the growth in house prices slowed, and ‘subprime’ borrowers faced foreclosure. By mid 2007, the problems had spread more widely, to classes of borrowers seen as less risky. CDOs and other derivatives, originally rated as AAA, were downgraded on a large scale and some went into default.

Throughout all this, the dominant view, informed by the EMH, was that nothing could or would go badly wrong. It was not until investment bank Bear Stearns was rescued from imminent bankruptcy in March 2008, that confidence started to crack. By this time, as the National Bureau of Economic Research subsequently determined, the US economy had been in recession for several months. But as late as August 2008, the most common response from financial markets was that of denial.

The meltdown began with the sudden nationalisation of the main US mortgage agencies, Fannie Mae and Freddie Mac in early September 2008. Two months later, the investment banking industry had collapsed, with Lehman Brothers bankrupt, Merrill Lynch swallowed by Bank of America, and Goldman Sachs and JP Morgan forced to seek the safety of government regulation. A year later, the list of casualties included banks around the world, whole countries such as Iceland, and the archetypal embodiment of corporate capitalism, General Motors. While a gradual recovery looks likely at the time of writing (June 2009), many more failures and defaults are inevitable.

In some ways, the boom and bust of  Every bubble in history has come with a story to show why “this time it’s different”. But the current crisis has two features that should spell the end of the efficient markets hypothesis once and for all. The first is that, in scale and scope, it is larger than any financial failure since the Great Depression. The estimated losses from financial failures amount to $4 trillion or about 10 per cent of the world’s annual income. Losses in output from the global recession are also likely to be in the trillions before the world economy recovers.

And, unlike the Great Depression, this crisis was entirely the product of financial markets. There was nothing like the postwar turmoil of the 1920s, the struggles over gold convertibility and reparations, or the Smoot-Hawley tariff, all of which have shared the blame for the Great Depression. Financial markets and major banks were lightly regulated by governments under systems that relied, in large measure, on risk assessments undertaken by the banks themselves, and based, in large measure on the ratings issued by agencies such as Standard & Poors and Moodys. 

All of the checks and balances in the system failed comprehensively. The ratings agencies offered AAA ratings to assets that turned out to be worthless, on the basis of models that assumed … Clearly, this was not simple incompetence. The entire ratings agency model, in which issuers pay for ratings, proved to be fundamentally unsound. But, these very ratings were embedded in official systems of regulation. Thanks to the EMH, crucial public policy decisions were, in effect, outsourced to for-profit firms that had a strong incentive to get the answers wrong. 

To these systemic failures was added the exposure of long-running fraud on a massive scale. The Ponzi scheme operated by Bernie Madoff, former head of the NASDAQ exchange and leading light of the New York financial sector, took place on a scale that matched the gargantuan growth of the financial sector itself. The original Ponzi scheme, promoted by Charles Ponzi on bogus investments in postal coupons 1920, brought in an amount equal to $5 million in today’s value. Madoff estimated the proceeds of his racket at $50 billion – ten thousand times Ponzi’s taking. And while Madoff put others in the shade, the collapse of the bubble brought to light a string of frauds involving tens or hundreds of millions of dollars.

The cases of Madoff and other frauds brings to mind JK Galbraith’s idea of the bezzle. The bezzle is the amount of undetected corporate fraud. As a boom continues, and everyone does well, people realise they can siphon off money and use it to make even more money. If they are threatened with detection, the original amount stolen can be returned to the till, and thye are still ahead. But, in a crisis, this can’t be done and, in any case, outside accountants are all over the books. So, embezzlers are caught and the bezzle shrinks. It stays small in the early stages of recovery when most decisions are being made by the cautious types who survived the crisis. But as the boom continues, hungrier and less-risk averse types come to the fore and the bezzle begins to grow again.

Under a system where the financial sector grows out of proportion to the real economy, and where, by virtue of the EMH, values recorded in financial markets are taken to be real, however absurd they may seem, the bezzle grew to unprecedented magnitudes.



john b 08.01.09 at 9:21 am

Absolutely excellent stuff. A few weird missing bits (e.g. 3rd paragraph), but nothing that affects comprehensibility.

I was going to list Amazon as a counterexample on the dotcom side, but apparently its IPO was 1997. That’s quite some time ago.


Mark L 08.01.09 at 11:44 am

Hi John,
Your explanation of the term “carry trade”, (“money can be made by borrowing money in yen, “carrying” it to the US market”), doesn’t match the usage in finance markets, or at least those in which I’ve worked (quant in Chicago, London, New York, Melbourne, Sydney since 1996). The term “cost of carry” refers to the interest a trader pays on her funding: the longer a trade is in place, the more she must pay to carry the trade. Borrowing Yen at low rates to fund trades elsewhere seeks to take advantage of the low cost of carry that Yen interest rates represent relative to those elsewhere, and hence is called the “carry trade”.
Mark L


P O'Neill 08.01.09 at 1:52 pm

One issue you might need to sort out is whether the exchange rate merits a separate chapter. A key ingredient of the 1990s/early 2000s crisis was a fixed exchange rate or at least a highly managed float — you mention this for Argentina but not the others. One route to the crisis was having used an exchange rate based stabilization to combat inflation, been hailed as a genius when inflation did some down and capital flowed in (attracted by the high interest rates and the assumption that they could get back out at the pegged rate) but then inflation didn’t fall enough, competitiveness gets destroyed and eventually there’s a huge current account deficit and the crisis cycle is on again. There are elements of EMH and more broadly classical economics in the thinking behind this approach to stabilization (in particular the optimism that inflation can fall quickly) but it’s a large topic to cover just on EMH.

Another interesting exchange rate angle is that it was an early warning sign that exchange rate speculation can add to real economy volatility and is not just a consequence of it. One example people liked from the early post Bretton-Woods era was the Irish pound. Up until 1979, fixed against Sterling and floating against DM. After 1979, floating against Sterling and fixed (or at least pegged against DM). If the nominal exchange rate regime is irrelevant, this shouldn’t have mattered much. In fact pre 1979 Ireland had real exchange stability against Sterling and volatility against DM, and vice versa after the exchange rate regime change.

They didn’t find impacts on other macro variables but they were writing before some of these major emerging market crises took place. I think by now the idea that speculation can be an independent source of volatility is mentionable in polite economic society.


Donald A. Coffin 08.01.09 at 2:24 pm

Not a substantive comment. In the second paragraph:
“The end of domestic deregulation took even longer.”
Should be “regulation,” right?


Odm 08.01.09 at 2:46 pm

In the second paragraph, should “The end of domestic deregulation took even longer” be domestic regulation?


Odm 08.01.09 at 2:49 pm

Reading it again, I suppose you mean that they had finished deregulating by the 90s, not that they started regulating again.


JSE 08.01.09 at 3:18 pm

For what it’s worth, I should say that I don’t really understand the guts of the LCTM trades well enough (even having read Roger Lowenstein’s book about it) to know whether I think the martingale is a good analogy for what went wrong there. My impression is that those guys thought they were playing a game with a positive expected value, unlike the martingale; maybe the problem is that in order to compute the expected value they were assigning probabilities to events that didn’t really have numerical probabilities in any meaningful sense (if you’re a frequentist) or whose “probabilities” were no more than subjective degrees of belief on the part of the various actors (if you’re a Bayesian.)


Neel Krishnaswami 08.01.09 at 4:11 pm

The argument I took from this section was something like, “the EMH was one of the central justification for weakening regulation and expanding the financial system, which is problematic because these markets create risk as much as they help manage it.” My immediate reaction was to wonder about those people who didn’t believe the EMH, or oppose regulation, and still supported efforts to expand the financial markets.

I think it would be very helpful if you could critique Robert Shiller. He doesn’t subscribe to the EMH, and yet he was still an extremely strong supporter of expanding derivatives markets — in his books Macro Markets and The New Financial Order he proposes using them to organize the entire system of social insurance. Likewise, the Basel II process seemed (at least from the outside) to be aimed at finding ways to use the markets to come up with rules resistant to regulatory arbitrage.


Martin Bento 08.01.09 at 7:36 pm

Claiming Google as the only dotcom success is surely an exaggeration. What about ebay? And etrade? And, yes, Amazon? And innumerable smaller firms from the 90’s? Any dating of the dotcom era that places Amazon outside it is, I would say, a misdating by definition, as Amazon was clearly part of that goldrush.

On more important matters, I’m glad you’re bringing in the collapse of the Bretton Woods currency regime and would like to see it brought into a discussion of “What is to blame for the 70’s?” Here we run into the figures of the liberal economic establishment like Romer and Delong who have made their peace with neoliberalism. Largely this seems to be based on an analysis of the 70’s as the result of liberal policy failures and an acceptance of the policies of Volcker and Reagan as necessary correctives. In your view, is this position also now questionable?


John Quiggin 08.01.09 at 8:46 pm

Martin & JB, Amazon and eBay have both experienced falling profits lately, but on a closer look, Amazon’s hit appears to be once-off. And neither looks like a good investment for anyone who bought in the 90s (at any rate, at prices available to the public). But I’ll clarify.

JSE & Neel K, I’ll try to address these points in the next section.

Mark L, thanks

P O’Neill, it would be good to have more on exchange rates, and I may have a bit to say in later chapters.


King Rat 08.01.09 at 9:50 pm

The Mosaic web browser wasn’t converted into Netscape. Instead, Netscape (then called Mosaic Communications) hired the creators of Mosaic to re-create their success. The Mosaic browser became Spyglass Mosaic through the Spyglass corporation, and Microsoft licensed that code to turn it into Internet Explorer. Anyway, the point being that the Mosaic browser was not turned into a commercial Netscape.


Charles S 08.01.09 at 10:59 pm

I’m not sure if corrections of typos is helpful, but 2 paragraphs before the LTCM Fiasco section starts, there is a stray ‘r’:

Malaysia, which r imposed controls


Charles S 08.01.09 at 11:00 pm

are helpful –


Z 08.02.09 at 2:11 am

Two very minor remarks. First, as I think I mentioned once already, I fail to distinguish the weak form of the EMH, especially when adding “consistently” and “simple” (which seems to mean public knowledge in that case), from a tautology. What would be an admissible empirical evidence against the statement “You cannot reliably predict the future outcomes of a market by a simple public method” (I think the “simple public method” part is important, because without it, we can’t distinguish lucky people from genuine predicters)? I don’t think your book would be better with a few sentences explaining this, but I would like to know, if anyone is kind enough to provide them.

My other remark is even more trivial, and as Jordan did not mention it himself, I probably shouldn’t, but introducing Jordan Ellenberg as a writer for Slate seems to me to be a very unfair description of his achievements (the first google hit on his name should be enough).


John Quiggin 08.02.09 at 2:18 am

Z, you certainly should mention things like this. Apart from correcting my total ignorance (and showing that I don’t reflexively Google everyone I meet, I guess), this kind of info is exactly what my publisher wants when I cite people. So, as a general call, if anyone has anything interesting I can say about anyone mentioned in the book (within the obvious limits), I’m all ears.


Abby 08.02.09 at 2:43 am

I may be missing something obvious, but I would like you to spell out a bit more fully the assertion “That is, where the EMH suggests that financial markets provide a way of managing economic risk, the evidence suggests that they are actually a major source of such risk” and why EMH leads to financial markets managing economic risk. Is it simply that financial markets offer a source of diversification? And if so, why is that reliant on EMH?

Also, one of the paragraphs that trails off mid-sentence appears to be the place where you are heading towards making that link that the existence of financial statement fraud that is successful in manipulating stock prices contradicts EMH-strong. That point needs to be made in order for the rest of the discussion to fit clearly in the chapter on EMH.


MR Bill 08.02.09 at 10:34 am

Casting for the blockbuster movie?
The only thing that comes to mind is Gilbert Gottfried as Alan Greenspan.
And maybe Billy Crystal as a sweating Ben Bernanke…


Sumana Harihareswara 08.02.09 at 10:54 am

If you keep blogging about the efficient markets hypothesis, I will have to stop assuming EMH stands for Emergency Medical Hologram.


Denis Drew 08.02.09 at 1:30 pm

I remember one week in back the 1970s when gold went from $450/ounce to $900/ounce and then dropped all the way back. Would have been a good time to dump the gold you bought at $32/ounce just before Nixon deregged the price a few years or so earlier. Anyway what we have here is an inefficient human brain hypothesis. Come back in 100 years for a complete delineation.

Meantime we have a hint from what we already know about the brain. The seat of our MOTIVES (A.K.A., social INSTINCT) operate in a pea sized part of the brain called the midbrain or limbic system or lizard brain leftover; the same (mostly reacting, not thinking) part of the brain responsible for a million American lawyers rising for the judge without one thinking: “I don’t have to salute the flag.” :-) See you in a hundred years for the rest of this discussion.

PS. The same tiny brain area responsible for thousands (tens of thousands?) of progressive academic researchers producing only one study (Card, Kruger) on the minimum wage — academics just don’t relate to folks below 50 percentile income. (For suggestions for more everyday reality based minimum wage studies go to: <a href=


Denis Drew 08.02.09 at 1:39 pm

Drew again: my HTML tag disappeared. Cut and Paste:

Trying HTML again: <a href=""every day reality based minimum wage thinking"


bunbury 08.02.09 at 4:41 pm

What this section needs is more explicit examples of the EMH being responsible for policy and that policy failing. The EMH is not the only reason people want deregulation and you could well believe in deregulation and indeed market solutions without swallowing the whole EMH. I don’t disagree with the thrust of the section and understand the need to be quite swift in covering it but I feel that it would be quite easy for the unsympathetic to dismiss some of these examples as either not counterexamples or, for policy issues not examples. Similarly more explicit examples of alternative policy prescriptions crowded out by a false belief in the EMH would be helpful to avoid being perceived as a back seat driver. In particular the Greenspan Put and reliance on credit ratings look to many people like examples of regulatory interference. Carry trades have, as far as I can tell, been very successful but, as suggested above, they often rely on a currency peg such as Thailand’s. They do of course suggest that actually existing markets are meaningfully inefficient but as examples of the failure of the EMH they overlap uncomfortably with the cases that a proponent of reliance on markets might use to illustrate the harmful effects of regulation.

Despite having asked for that I think it will be difficult because in policy circles I would be surprised if practical recourse to the EMH gets much more explicit than Mrs. T’s “You can’t buck the market” and will therefore prove very slippery.


Substance McGravitas 08.02.09 at 4:53 pm

LTCM needs to be shown in long form before its acronym..


Substance McGravitas 08.02.09 at 4:57 pm

On the other hand, econometric studies given little support

Have given or gave.


Substance McGravitas 08.02.09 at 5:06 pm

if converted into euros and spent in Europe 1


As with the closely related equity premium puzzle (see CH ..), it is easy enough to see that the standard theory underlying the EMH (and the closely associated capital asset pricing model).

Needs verb.

along with more prosaic correction of errors

Being as prosaic as possible, hope that’s okay.


R.L. Love 08.02.09 at 5:39 pm

Good stuff. Because nit-picking is encouraged here I have a couple of things. First, it distracted me some that 2 of the 3 rating agencies were linked to the conflict of interest fiasco, does the missing agency own the company publishing your book? Do you consider this missing company less guilty?
Second, I do not know where you are going from what is shown above but I think far too little is being said about “controls on movements of foreign exchange”. You touch on Malaysia’s success due to a disregard for IMF guidelines and this, along with simular successes by China etc., especially those limitting short term foreign investment, seem very much at odds with the core intentions of the developed world in regards to Globalization. Lending does require borrowers does it not, and the developed nations seem to have put far too many of their eggs into a poorly constructed basket.


Jim Caserta 08.03.09 at 1:13 am

I don’t completely understand how LTCM interacts with the EMH. If the EMH were true, then how would LTCM have made money?


Richard H. Serlin 08.03.09 at 3:18 am

“Broadly speaking, this weak version of the EMH is consistent with the evidence. At least, there are no simple and reliable trading strategies that have been shown to beat the market consistently.”

I don’t think this is true. Here are two things that I suggest you consider for substantially beating the buy and hold market portfolio, a la CAPM, in risk-adjusted return:

1) Trading strategies based on P-E ratio – A good starting place to examine the research is Christopher Carroll’s recent Economists’ Voice article, “Recent Stock Declines: Panic or the Purge of “Irrational Exuberance”?”.

2) Trading strategies that favor value stocks and small stocks – Here I suggest starting with the short book, “The New Finance”, 4th Ed., 2009, by Robert Haugen, Emeritus Professor of Finance at the University of California, Irvine. The writing is very hyperbolic, but a lot of good research in top academic journals is pointed to and explained.


John Quiggin 08.03.09 at 8:22 am

Richard, this is a problem of posting in bits. The weak EMH only rules out profitable strategies based on past prices, not those based on P/E ratios or value investing, which are ruled out by the semi-strong EMH.


Katherine 08.03.09 at 8:47 am

It’s noddy time again! If you are really writing for the layperson (even the educated, interested one) then you should probably explain econometrics a bit.


Katherine 08.03.09 at 9:19 am

Also, and I may be flogging a dead horse here, but I continue to think that just using the acronym “EMH”, and then occasionally qualifying that with “weak”, “semi-strong” and “strong” when you have to draw a comparison between them, has the potential for enormous confusion. And at best it’s unclear.


Tracy W 08.03.09 at 9:39 am

The evidence for the strong forms of the EMH was never particularly convincing.

And you have yet to identify any economist who ever actually believed the strong form of the EMH. Fama himself said that he didn’t believe in it. To quote, again, the 1970 paper:

C. Strong Form Tests of the Efficient Markets Hypothesis. … We would not, of course, expect this model to be an exact description of reality, and indeed the preceding discussions have already indicated the existance of contradictory evidence. …

page 28 of the pdf,
And from pdf page 33 of the same paper:

One would not expect such an extreme model to be an exact description of the world, and it is probably best viewed as a benchmark against which the importance of deviations from market efficiency can be judged.

You say that you want comments and corrections, but I’ve made this point before and it doesn’t appear to make any difference to what you write. Why do you want to give the impression that economists believed strong-form EMH when they didn’t?


Kevin Donoghue 08.03.09 at 10:35 am

Tracy W: And you have yet to identify any economist who ever actually believed the strong form of the EMH.

You have a point but I think you are missing a more important point. Friedman’s Methodology of Positive Economics is the inspiration for a two-step which is very popular with devotees of Panglossian models. Step 1: this model is totally unrealistic, that’s what’s so great about it; if you don’t understand that you don’t understand scientific method. Step 2: this model is the one we teach in all our courses; why would you allow policy to be shaped by old-fashioned models developed by defunct economists?

So you see, it’s not important that they don’t actually believe the strong-form EMH. They have found a way to exploit the policy implications of models they don’t believe in. Ideally John Quiggin’s book should deal with this philosophical dodge, but I suspect it’s more John Holbo’s kind of thing.


Chris 08.03.09 at 4:02 pm

Friedman’s Methodology of Positive Economics is the inspiration for a two-step which is very popular with devotees of Panglossian models. Step 1: this model is totally unrealistic, that’s what’s so great about it; if you don’t understand that you don’t understand scientific method. Step 2: this model is the one we teach in all our courses; why would you allow policy to be shaped by old-fashioned models developed by defunct economists?

In that case, sign me up for some negative economics. If enough people had been a little more dismal at the right times, we might not have this mess.

Great excerpt, very interesting reading (no mean feat for a passage about finance and economics!) I think other people have already pointed out the couple of apparent omissions/sentence fragments.

I think it’s interesting that LTCM’s business model was based on expecting the market to correct itself, given that any opportunity to profit by this presumes that (a) the market isn’t already correct and (b) you know where the market is going better than the market does.

I also found the mention of Robertson’s attempt to short the tech bubble particularly interesting – it seems like a concrete example of the saying that the market can remain irrational longer than you can remain solvent.


Richard H. Serlin 08.04.09 at 1:00 am

For the chapter covering the equity premium puzzle, I was wondering if you might consider a supply-based explanation that I have not seen in the literature:

All of the explanations for the equity premium puzzle I have seen in the literature are based on the demand side; trying to find utility functions for a representative investor and ex-ante probability distributions for returns that would explain investors demanding such high average returns for stocks relative to bonds, rather than bidding those returns down. But I suggest a supply based explanation: The long run supply curve for corporate stock may simply be extremely long and flat, and consistently about 5 ½ percentage points in return higher than the premium bonds supply curve, even at stock quantities as high as the entire national savings rate.

Why would this be? I posit that stock might simply allow a firm to create more wealth with an investment dollar than bonds, and this is because of the flexibility of stock. Firms are able to invest in high return long run projects when they raise money with stock that they sometimes cannot when money is raised from bonds due to the short run constraints of having to make interest payments and satisfy bond covenants.

With stock the firm has greater flexibility to take large projects which may make little or no money for years, which may even lose money for years, but which overall will be very high return due to long run profits. There are many areas where short run constraints (often undue ones) greatly decrease optimization. Such areas include business, politics, and academia.

Warren Buffet, arguably the most successful investor in history, constantly attributes his success to unusual efforts and willingness to avoid short term constraints so that he can choose the projects, within companies he controls and in buying stock, that offer the highest NPV. For example, in discussing his use of insurance company funds rather than debt to finance projects, he writes in his Berkshire Hathaway statement of business principles , “…they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt — an ability to have more assets working for us — but saddle us with none of its drawbacks.”

For more, see “Supply Based Explanation of the Equity Premium Puzzle”, by Richard Serlin.


mike ferrell 08.05.09 at 8:55 pm

Very interesting stuff, inclined me to dig up Lowenstein’s book. Check Chapter 7, where Lowenstein identifies LTCM’s “signature trade” that “set the firm ineluctably on the road to disaster”. It is trading on “equity vol” – detecting when market options are mispriced compared to historical market volatility; Black-Scholes shows that expected volatility affects option prices – the more the expected volatility, the higher the option prices should be. LTCM would bet against options prices when they were out-of-whack with historical market volatility by shorting them with gigantic leverage (their other signature). One thing that needs to be pointed out is that LTCM had to use leverage to make big money, since the moves they were betting on were low-return, low-risk bets. Of course, when you leverage, up goes the risk!


Kenny Easwaran 08.06.09 at 2:00 am

It seems to me that the LTCM story supports the EMH rather than undercutting it. At least, that seems to be the case, given the way that you’ve told the story – perhaps there’s another way to tell it that makes more clear why you think it undercuts the EMH. You analogize it to the martingale betting system on coin flips, which relates to the fundamental theorem of martingales, which is that any bounded stopping time on a martingale must have expectation 0. LTCM seemed to believe that by building up large volumes of trade and leveraging, they could almost certainly make money off the tiny inefficiencies in the market. However, their “almost certainly” wasn’t good enough, since there was a slight risk of enormous losses (as they discovered). So the market was more even efficient than they had thought – even though they found a strategy that was almost certain to profit off the market, it ended up having no net expected return. But perhaps I’m understanding the story wrong?

As a few more minor points, it seems unfair to add the footnote that Madoff was involved in the founding of NASDAQ unless you want to allege that NASDAQ itself was actually a scam.

Also, aren’t Amazon and eBay two other companies founded during the dotcom boom that are making nice profits? (Of course, Amazon took many years to do it, but I thought they’ve generally been doing well, and eBay even better.) You might also count PayPal and a few others that were founded at that time and then absorbed by other companies.

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