Eugene Fama just received a Nobel Prize for his contributions to the theory of “efficient financial markets,” the dominant theory in financial economics that asserts that markets work ideally if not constrained by government regulation. The fact that economic “science” teaches that unregulated financial markets work effectively helped financial institutions and the rich accomplish their goal of radical financial market deregulation in the 1980s and 1990s. Deregulation, in turn, not only contributed to the rising inequality of the era, it helped cause the global financial market crisis that began in 2007 and the deep recession and austerity fiscal policies that accompanied it.
The theory of efficient financial markets requires the union of two ideas: the “efficient market hypothesis” (or EMH) and optimal (security) pricing theory (OPT). Both the EMH and OPT are built on crudely unrealistic assumptions that would lead anyone not indoctrinated in a mainstream PhD program to conclude that efficient financial market theory is a fairly-tale rather than serious social science.
The EMH is simply an assumption or assertion with no supporting evidence that all information relevant to the correct pricing of securities is known by all market participants. For long-term assets such as stocks and bonds, the relevant information is the cash flows associated with each security in every future time period. Yet it is logically impossible for anyone to know this information because the future is not yet determined in the present; the future is uncertain. Nevertheless, defenders of efficiency adopted the “rational expectations” hypothesis, perhaps the most ludicrous assumption in the history of social science, which asserts that all investors know the correct probability distributions of all future security cash flows and believe that they will not change over time.
The assumed complete and correct data about the future is then plugged into one of the basic mainstream models of optimal security pricing, such as the capital asset pricing model (CAPM), which specifies agents’ preferences concerning the risk and return associated with every possible portfolio of securities. The combination of EMH and a theory of optimal pricing determine security prices that are efficient in that every investor has selected the risk-return profile in a portfolio that maximizes her welfare, and financial resources are made available to those who can make the most productive use of them. Market prices are assumed to be in equilibrium at all times, even though the data show that market prices are much more volatile than would be compatible with the assumption of perpetual equilibrium.