«I say I won» – Eugene Fama, the ‘father’ of the Efficient Markets Hypothesis

The Efficient Markets Hypothesis is today under huge criticism from one part of Academia and analysts. EMH was ‘linked’ with the bubble policies by critics. Many will consider it a collateral victim of the present financial crisis. Professor Fama counterattack in this short interview: “I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m still deep in the minority. If the EMH took over the investment world, I missed it. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems.”

At the moment this interview went, Nobel Paul Krugman wrote a harsh criticism about this financial economics school of thought at The New York Times Magazine and a few additional comments at his blog. Eugene Fama promptly told us: “Haven’t seen it, but I pay no attention to him.”

Eugene Francis Fama, 70, is an American economist, credited for the so-called Efficient Market Hypothesis (EMH). Although a Bostonian he did his M.B.A. and Ph.D. from the Graduate School of Business at the University of Chicago with a dissertation in 1964 about ‘The Behavior of Stock Market Prices’. His doctoral supervisor was Benoit Mandelbrot, a mathematician known as the father of fractal geometry. Fama developed his teaching career at the University of Chicago as professor of Finance at the Graduate School of Business.

His most famous article was published in May 1970 entitled “Efficient Capital Markets: A Review of Theory and Empirical Work” (Journal of Finance 25 (2): 383–417.). The article is a must in the ranking of scientific citations and one of its first sentences is well known and quoted: “A market in which prices always ‘fully reflect’ available information is called ‘efficient’.”

This theory is now under bold criticism from other economic schools of thought, particularly Keynesians like Paul Krugman (his last article at The New York Times is a kind of Keynesian Manifest even against the ‘bastard neo-Keynesianism’) or behavioral economists like Robert Shiller and Nobel George Akerlof (just published their most recent book entitled Animal Spirits). Krugman concluded in his article of this week-end at The New York Times: “In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.”

But, as readers will conclude from this short interview, professor Fama “delinks”, “decouples” (using a buzz from geoeconomy) his theory from the roots of the recent crisis: “The two are totally unrelated.”

He can be followed in the web at his forum with Kenneth French.

Interview by Jorge Nascimento Rodrigues, September 4-6, 2009

QUESTION: Do you think the financial instability hypothesis of late professor Hyman Minsky proved more accurate than the EMH? Or they deal with different realities?

ANSWER: Sorry, but I’m not familiar with Minsky’s work.

QUESTION: Some economists particularly since the 1990s refer that the financial system is intrinsically instable, that if no counter-cyclical measures are taken it will develop a bubble and burst pattern generating inevitable financial crisis. Do you think recent events prove the argument?

ANSWER: If financial firms bore all the costs and benefits of their actions, I don’t think the system would be “inherently” unstable. When financial firms get the benefits of good times and taxpayers bear the losses of bad times, the system can become unstable.

QUESTION: Critics today “linked” the so-called Greenspan put and the Great Moderation theories to the EMH. Also the policies regarding the fueling of bubbles are a “fault” of the EMH. It seems nowadays that EMH is a kind of an original sin for all the policies the FED and other politicians and technocrats did in the last 20 years. Is EMH responsible for all this bandwagon?

ANSWER: Regarding your question, we can take the example of Justin Fox book (The Myth of the Rational Market, June 2009). I repeat what I said recently. The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world’s investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with “bubbles” in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s. The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of banks and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying position in the financial industry have a tough time finding a job if they accept the EMH. I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m still deep in the minority. If the EMH took over the investment world, I missed it. The Fox book is an example of a general phenomenon. Finance, financial markets, and financial institutions are in disrepute. The popular story is that together, they caused the current recession. I think one can take an entirely different position: financial markets and financial institutions were casualties rather than the cause of the recession. But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. I think it’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn’t develop as they did? Toward the end of the book, Fox concludes that passive investing is the right choice for almost all investors. My academic friends in behavioral finance (for example, Richard Thaler) also almost always end up with a similar conclusion. In my view, this is an admission that the EMH provides a good view of the world for almost all practical purposes. At which point, I say I won.

QUESTION: The ongoing crisis is a “normal” regular correction in the business cycle, or is it a “species” of a different kind, eventually similar in the substance to other big ones like 1873/79 and 1929/1933 as most analysts and politicians said?

ANSWER: Every recession is a little different.

QUESTION: Facing the present crisis, would you correct any aspect of the EMH?

ANSWER: I think the two are totally unrelated.

9 Responses to “«I say I won» – Eugene Fama, the ‘father’ of the Efficient Markets Hypothesis”

  1. […] Nota: Extractos, traduzidos, de uma entrevista publicada em inglês aqui. […]

  2. […] dos Estados Unidos. Curioso, também, referir que Eugene Fama, na curta entrevista que realizámos (aqui), declinou responder sobre o assunto, alegando “não estar familiarizado” com os pontos de […]

  3. […] dos Estados Unidos. Curioso, também, referir que Eugene Fama, na curta entrevista que realizámos (aqui), declinou responder sobre o assunto, alegando “não estar familiarizado” com os pontos de […]

  4. […] correntes académicas em fazerem o seu “de-coupling” em relação ao que ocorreu (vide as entrevistas que Eugene Fama tem dado recentemente ou diversas intervenções na recente conferência ‘What’s wrong with […]

  5. […] excessive formalism, equilibrium abstract models, like the DSGE, and efficient market hypothesis of Eugene Fama) which dominated the mainstream macroeconomics in the last decades, economist William White, […]

  6. I have a question for believer of EMH..
    If stock market is efficient,
    Is fundamental analysis still needed to examine whether the price of stock is undervalued or overvalued? as I know in EMH theory, market prices are already reflect all information available on the market.

    sincerely,
    laelie

  7. Fama is contradictory in his answers. He recognizes that banks do not take market efficiency seriously, but still asserts that the market is efficient. Also he said that students who believe in EMH are not hired while others are.
    The problem is that central banks take it for granted that investors are rational and markets are efficient, that is why they do not intervene directly in good times to bring asset prices back to their fundamental value.
    But as pointed out by Minsky, bubbles are unsustainable and eventually burst, which prompts financial crises and government intervention.
    The causal direction is
    no intervention in good times = inefficient market = crises = government intervention in bad times
    not the other way as suggested by Fama….

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