Eugene Fama Drinks His Own Brand of Kool-Aid
Famed economist Eugene Fama has a novel take on the financial crisis. Rejecting as “fantasy” the idea that Wall Street is in any way to blame for the mess, he says that “financial markets and financial institutions were casualties rather than the cause of the recession.”
Fama also makes a curious claim regarding the “efficient market hypothesis,” which he pioneered in the 1960s and ’70s while at the University of Chicago. The theory essentially says that markets are an efficient way to set prices, such as for stocks, because they reflect all information available to participants at any given time.
The EMH has been in dispute since the day it was born. And it has taken it on the chin in recent years from folks (like me) who think it’s dead wrong, and dangerous to boot.
But there’s no disputing the theory’s influence on mainstream financial thinking. The EMH has informed a couple generations of public policy regarding financial industry regulation. It is a pillar of the idea, now groggier than a punch-drunk fighter, that markets are self-correcting and that the best thing government can do is get out of the way.
Fama defends his theory against charges that it laid the ideological groundwork for the financial crisis by saying that, well, no one believes in it, anyway. Or rather, no one who matters.
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 percent 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 commercial 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.
These are clumsy, if convenient, dodges. Financial institutions are of course both casualties and cause of the meltdown (’twas ever thus, by the way). AIG sold too many credit default swaps, and now it — and we — are paying the price. Countrywide wrote mortgages for anyone with a pulse, and now it’s a corpse. One day leverage is your friend, the next it’s picking its teeth with your balance sheet.
As Fama must understand, it doesn’t matter whether fund managers and other big investors truly believe that markets are fundamentally efficient — only that they appear to believe. Certainly financial regulators and central bankers acted as if they did. And voodoo, if you lend credence to it, can kill you. Especially if the witch doctors have important jobs and their licensed apothecaries push the mojo for fun and profit.
Besides, Fama is too modest by half. As John Maynard Keynes famously said, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
Alain Sherter is an award-winning business journalist who has written for The Deal and Thomson Financial Media.
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