Pictures of Shanghai in 1990 and 2010
Ross Douhat nails it

The efficient-markets-hypothesis-didn't-predict-this meme

I've seen--several times recently--the odd claim that the "market efficiency hypothesis" predicted that a severe drop in stock market prices was all but impossible. (Sometimes this claim is extended: the market efficiency hypothesis thereby induced market participants to be overconfident, which, in turn, helped create the recession.) The most recent instance is this, from distinguished Yale economist Robert J. Shiller:

In the decades prior to the current financial crisis, economists gradually came to view themselves and their profession in the same way, encouraged by research trends. For example, after 1960, when the University of Chicago started creating a Univac computer tape that contained systematic information about millions of stock prices, a great deal of scientific research on the properties of stock prices was taken as confirming the "efficient markets hypothesis." The competitive forces that underlie stock exchanges were seen to force all securities prices to their true fundamental values. All trading schemes not based on this hypothesis were labeled as either misguided or fraudulent. Science had triumphed over stock-market punditry—or so it seemed.

The financial crisis delivered a fatal blow to that overconfidence in scientific economics. It is not just that the profession didn't forecast the crisis. Its models, taken literally, sometimes suggested that a crisis of this magnitude couldn't happen.

While I almost always hesitate to criticize my betters, I'll overcome the hesitation this time. This is not the market efficiency hypothesis I was taught. All that hypothesis posited was that stock market prices were the best available forecasts of firm values. It doesn't now, nor did it ever, posit that the stock market was always right.

Maybe if I had gotten an Ivy League degree I would know better.

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