Proof of the Efficient Markets Hypothesis


The Efficient Markets Hypothesis is something that drives a certain sort of lefty into a slavering fury. For they take it to mean that we are saying that all markets all the time markets is the most efficient method of organising our socio-economic system. Thus when something like the Great Financial Crisis shows that markets aren't perfect they are able to crow that obviously markets aren't efficient and thus they get to tell us all what to do instead.

However, that's not actually what the efficient markets thing is all about. Rather, it comes in several flavours, the "weak" form of which is an obvious truism. When deciding what prices should be in a market markets are efficient at processing the information about what prices should be in a market. The semi-strong form goes on to say that markets will process all information openly available, the strong form that markets will process all information, publicly available or not.

There is, as you will note, absolutely nothing in this at all that says that organising defence as a market will be efficient, or that there should or should not be a welfare safety net. All that is under discussion is how well markets process information. And we seem to have some really rather strong evidence in favour of the strong form:

We estimate the impact of coups and top-secret coup authorizations on asset prices of partially nationalized multinational companies that stood to bene fit from US-backed coups. Stock returns of highly exposed firms reacted to coup authorizations classi fied as top-secret. The average cumulative abnormal return to a coup authorization was 9% over 4 days for a fully nationalized company, rising to more than 13% over sixteen days. Pre-coup authorizations accounted for a larger share of stock price increases than the actual coup events themselves. There is no effect in the case of the widely publicized, poorly executed Cuban operations, consistent with abnormal returns to coup authorizations reflecting credible private information.

As you can see, market prices reflect what the spies are going to do: something which we would regard as being pretty secret information really. Yet markets do process it efficiently, to the extent that what is still secret about what is going to happen moves markets more than what actually happens when it happens.

Yes, of course, the likely explanation of this is spies and their friends loading up on stocks that will benefit from what they're about to do: insider trading in fact. But that's still strong proof of the strong version of the efficient markets hypothesis: for we don't say that the processing of information by markets must necessarily be moral, just that it's efficient. As insider trading is, even if it's not moral/legal.

As an aside, one joy is that I found this research at Henry Farrell's place, who is a co-blogger at Crooked Timber with John Quiggin. Who has just published a book which uses the Great Financial Crisis to prove that the strong version of the efficient markets hypothesis is obviously and clearly wrong. Should be an interesting conversation between the two of them really.