Can The Efficient Markets Hypothesis Survive?
George Manson University economist Tyler Cowen has written an interesting new paper entitled "A Simple Theory of the Financial Crisis." That's a good title, because I'm very much on the lookout for simple theories of the financial crisis. The paper's main mission, it seems to me, is to protect the efficient markets hypothesis from the fallout of the financial crisis. The key bit of the paper comes on page three:
In a strict rational expectations model, we might expect some people to overtrust others and one view of rational expectations is that investors’ errors will cancel one another out in each market period. Another view of rational expectations is that investors’ errors will cancel one another out over longer stretches of time but that the aggregate weight of the forecasts in any particular period can be quite biased owing to common entrepreneurial misunderstandings of observed recent history. In the latter case, entrepreneurial errors magnify one another rather than cancel one another out. That is one simple way to account for a widespread financial crisis without doing violence to the rational expectations assumption or denying the mathematical elegance of the law of large numbers.
I'd like to see what Justin Fox -- author of the excellent new book The Myth of the Rational Market -- would say in response. Luckily, he has a blog where he could write such a response, and hopefully this link combined with that book plug will act as a bat signal of sorts.
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