Jeremy Grantham says belief in an efficient market led to the crisis.
FOR SOME MONTHS now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been complaining about - of all things - the efficient market hypothesis.
It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices.
The stock market, in other words, is rational.
In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious criticism. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale University, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices - meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, followed by the housing bubble.
These days, it would be difficult to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham has hardly been mollified by its decline. In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.
“In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” - not to mention “flat-out bursts of irrationality.”
He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”
I couldn’t help thinking about Mr. Grantham’s screed as I was reading Justin Fox’s new book, “The Myth of The Rational Market,” an engaging history of what might be called the rise and fall of the efficient market hypothesis.
Mr. Fox is a business columnist for Time magazine (and a former colleague of mine). His thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons, they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.
Mr. Fox argues, echoing Mr. Grantham, that the efficient market hypothesis played an outsize role in shaping how America thought and acted in the last 30-plus years. But Mr. Fox disagrees with him by also arguing that the effect wasn’t necessarily all bad.
“There are no easy ways to beat the market,” Mr. Fox said. If you want to point to the single best thing the efficient market hypothesis taught us, that is the lesson: we can’t beat the market. Indeed, the vast majority of professional money managers can’t beat the market either, at least not on a regular basis.
As Mr. Grantham sees it, if professional investors had been willing to acknowledge aberrations in the market - and trade on the fact that the market was out of whack - they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble - because, after all, stock prices were rational.
I asked Burton G. Malkiel, the Princeton University economist, what he thought of Mr. Grantham’s theories.
“It’s ridiculous” to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. “If you are leveraged 33- 1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank - which is what happened to Bear Stearns - how can you blame that on efficient market theory?”
Then we started talking about bubbles. “I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”
I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.
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