The Curious Case of Benjamin Buttonwood
Despite the apparent snobbery attached to saying this – I am an avid reader of The Economist. In fact I have used The Economist as a teaching aid in my past courses in business economics and financial markets in order to illustrate many of the broad principles that my students and I have often discussed.
You can understand, then, when I say that I was quite disappointed to read the most recent edition of the periodical’s Buttonwood column, found here. Titled ‘The grand illusion’ the article explains “how efficient-market theory has been proved both wrong and right.” Ugh. Even the usage of nomenclature is poor. The efficient-market hypothesis‘ (EMH) isn’t a theory at all; it’s an academic concept against which certain empirical observations can be understood – a benchmark, so to speak. Market dynamics are characterized as being either consistent with the hypothesis, or not.
This isn’t the only mistake made by the column’s authors. (In fact, I can’t really blame them alone for the use of the word ‘theory’ in this context. A Google search of “efficient market theory” (with quotes) yields 180,000 results while “efficient market hypothesis” generates 460,000.) The article’s first reference to the “theory’s” failures is the momentum effect – the empirical result that a portfolio of stocks that have recently risen in price will likely tend to do so. A similar – but opposite – effect can be observed in the worst performing stocks. This is not bothersome to me, as it is a perfectly valid empirical counterpoint to EMH. It’s what the authors say next that is troublesome.
“Belief in efficient-market theory made the authorities reluctant to restrain either the dotcom or the housing and credit bubbles.” I’m not sure that this is true. A belief in EMH would be likely to pause regulatory changes (for example) that would reel in market expansion, but so too would the assumption that existing regulations are sufficient. In fact, in many cases the latter would nearly imply a disbelief in EMH – if those in charge believed that regulations are necessary to mitigate the effect of inefficiencies in the flow of information.
Points made later in in the Buttonwood column are more egregious than the above. The authors lay EMH on top of investment decisions made at commercial banks: “Many lament the demise of old-style banking, the “three-six-three” model where bankers borrowed money at 3%, lent it at 6% and were on the golf course at 3pm. That model broke down because markets were fairly efficient; the margins on lending to corporations became too low.” [My italics] “That model” may very well have broken down because markets were fairly efficient, but not primarily due to the informational efficiency that is considered in EMH. Efficiency is a term that can be applied to a variety of concepts in the context of economic markets. The efficiency that is described in EMH is that of the transfer (and assimilation in prices) of value-related information. It’s unlikely that this is the type of efficiency that lead to the demise of this old-school banking model. A much more likely candidate is the increase in banking industry competition after economy-wide deregulation in the 1970s.
Frankly, I’m disappointed in the Buttonwood columnists for their overarching, hand-waving arguments in this latest installment. However, I see this as just the most recent of a number of columns that have trended downward in quality. While I still enjoy reading the magazine, this is just one more point of criticism.
