What went wrong?

The efficient market hypothesis stipulated that bubbles could not exist and that the market is the best disciplining device.


For more than three decades, economists’ advice to policy makers has been based on a deep belief in the efficiency and stability of financial markets. These markets have been thought of as coming extremely close to the ideal, in which prices provide accurate signals and hence efficient resource allocation. Because markets would efficiently make use of all available information to determine the price of an asset, speculation has been regarded as a way of stabilizing asset prices. The idea that speculation is a stabilizing factor goes back to contributions by Milton Friedman (1953), who reasoned that as soon as prices move away from their equilibrium values, speculators could make money by betting on a price reversal. Speculators would thereby contribute to returning  prices to equilibrium. The conclusion was that the less regulated financial markets were, the closer they would be to the ideal market. The growth of the financial sector was thus a sign of its success and finance an important contributor to economic growth.

The main theoretical underpinning of this strongly market-based paradigm were the seminal contributions of Eugene Fama (1965a, 1965b, 1970) and his formulation of the efficient market hypothesis (EMH). According to this hypothesis market prices always reflect a good estimate of an asset’s intrinsic value (Fama, 1965a). This implied that irrational deviations of a price from its fundamental value could only be transitory at best, and that investors could not on average beat the market. Either the aggregate irrationalities of investors would cancel each other out, or rational speculators could make money by betting against irrational behavior.

The more an asset was traded, the more information would thus be incorporated into its price. In other words, higher liquidity generates more information and contributes to the stability of financial markets. This provided the strongest argument for a growing financial sector, the invention of new debt instruments and derivatives, and financial globalization as a whole. And led to the belief that financial crises could only occur in countries with undeveloped financial systems.

It followed from this analysis that the regulation of financial markets was best left to the market itself. The market would act as a disciplining device (Greenspan, 2003), because banks should have a self-interest in protecting the interests of shareholders, As a result, regulation tended to focus on the excessive risk-taking of individual banks and not at the system at large. Under this paradigm irrational exuberance and credit bubbles simply could not exist. As Eugene Fama (2010) said in an interview: “I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

Finally, the deep belief in the efficiency of markets led to the idea that capital should flow freely, and that financial markets would be ever more efficient the bigger they were and the more assets were traded. Increased financial activity was seen as clearly contributing to economic growth.

The Global Financial Crisis (GFC) has dealt a blow to the belief in efficient and self-stabilizing financial markets. Ever since it occurred, a growing number of eminent economists have questioned this belief. After the worst economic crisis since the Great Depression, it seemed clear that unfettered finance had not delivered on its promise. It was clear that a meltdown of the global financial system in 2008 was only prevented by unprecedented central bank and government intervention. The crisis revealed substantial mispricing of assets linked to the US real estate market and revealed the banking sector’s exposure to systematic risk.

The GFC was preceded by three decades of ever more frequently occurring financial crises around the world, adherents to the then prevailing paradigm had arguably ignored earlier warnings. The Savings and Loans crisis in the US in the 1980s and 1990s, the Asian financial crisis of 1997, Japan’s real estate bubble in the early 1990s and the Dot-Com bubble at the turn of the millennium were difficult to square with the assumptions underlying the EMH. Finally, the increasingly irrational contagion of the eurozone crisis to countries with even solid fundamentals between 2010 and 2012 also contradicted EMH thinking, as well as providing further evidence that financial crises are a recurring phenomenon.

If the frequency of financial crises have increased since the 1970s (see chart), why were banking crises almost absent in the immediate post-war decades? Why have crises occurred more frequently since financial markets have been deregulated? New research has shown that credit growth is a powerful predictor of financial crises, which are often private credit booms gone bust (Schularick and Taylor, 2012).

Contrary to market fundamentalists’ assumptions, asset prices can diverge from their fundamental value for extended periods of time. Prices are not necessarily formed by traders incorporating all the newest information; sometimes they just extrapolate from existing trends. The foundations for a possible new and more market-sceptical paradigm were laid long before the GFC. In the early 1980s. Robert Shiller (1981) questioned the core assumption of the EHM when he demonstrated that stock markets were a lot more volatile than corporate fundamentals would justify. These empirical findings supported the influential yet controversial view by Hyman Minsky (1977) and Charles P. Kindleberger (1978) that over-optimism brings about credit expansion. The Minsky-Kindleberger view stipulates that extended periods of economic stability create overly optimistic expectations among investors which create credit bubbles and thereby produce cyclical instability. This view has received much empirical support in recent years (Baron and Xiong, 2017; Mian and Sufi, 2009; Mian et al., 2017; Fahlenbrach et al., 2017).

Until 2008, the Minsky-Kindleberger view had been on the fringe of the economics discipline. However, economists have come to acknowledge that prices do not always reflect perfect information. Indeed, asymmetries exist which can even lead to market failure (Akerlof, 1978; Spence, 1978; Stiglitz and Weiss, 1981). Investors often make decisions about the price at which they are prepared to purchase or sell an asset by employing ‘rules of thumb’ reasoning. This can lead to herding behavior, as investors are influenced by the optimism or pessimism of other investors. In the real world, the strong assumptions of the pre-2008 paradigm do not hold. Instead, as critics like Schularick state, speculation is often destabilizing and the financial system has an inherent tendency towards a boom and bust cycle.

The recent experience of Argentina gives a good illustration of this. In 2017 the housing market in Argentina boomed, only to see a sharp reversal of prices in 2018, leading to sharp fall in the value of the currency and the imposition of capital controls (Bloomberg, 2019). However, boom and bust cycles are not restricted to developing or emerging market economies. According to the latest UBS Global Real Estate Bubble Index, the risk of a housing bubble is particularly strong in the eurozone. Housing prices in Paris, Munich, Frankfurt and Amsterdam are in bubble-risk territory having reached all-time highs (UBS, 2019).


Read Part 3: Remaking Finance: New Economy in Progress


  • Finance has five main activities in a market-based economy: 1. ease the exchange of goods and services; 2. mobilize and pool savings; 3. facilitate the trading, diversification, and management of risk; 4. monitor investments; 5. exert corporate governance and produce information about possible investments.

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