Investment Line: Are finance professors and their theories to blame for the financial crisis?

Finance professors have long since emerged from obscurity, attracting worldwide attention, especially during the financial crisis of the last couple of years.

The efficient market theory in particular has come under scrutiny with a growing number of academics looking at whether it not only describes market behaviour but actually also influences it.

Over the past few months several high profile commentators have weighed into the debate. In the Wall Street Journal, Jeremy J. Siegel said the answer was an unequivocal no. His thesis was that it was the US Federal Reserves’ fault for not cracking down on the housing bubble sooner.

On the flipside, FT columnist Martin Wolf argued that yes efficient market theory was to blame, because efficient market theory persuaded the Fed not to act to prick the property bubble.

So who is right? Justin Fox, the author of The Myth of the Rational Market, perhaps unsurprisingly says that the answer lies somewhere in the middle. He quotes Benjamin Graham, who in 1962 told the 25^th anniversary bash of the New York Society of Security Analysts that: ‘Neither financial analysts as a whole nor investment funds as a whole can expect to beat the market, because in a significant sense they are the market.’

Fox charts the history of finance academia, noting that efficient market theory took root in the text books back in the 1960s even though some of the wobbles in the 1970s showed up its short-comings. He even quotes Bill Sharpe, who showed unshakeable faith in the theory in the light of the 1987, saying ‘it’s conceivable that a change in the well-informed forecast of future economic events moved the markets as it did. On the other hand it is pretty weird.’

‘Clearly academic finance was struggling a little with the efficient market hypothesis at that moment,’ Fox says. By the 1990s, he adds, people began to look at the theory through a different prism focusing on whether or not you can predict bubbles. He says that many people believe that you can, but actually making money off them is another thing altogether.

As University of Chicago finance professor John Cochrane puts it: ‘The central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where the markets are going.’

Added to this, there is a growing feeling that central banks should take a greater role in nipping these asset bubbles in the bud, but their at times unpredictable behaviour makes arbitraging mispricings all the more difficult.

So back to the argument of whether finance boffins and their theories are to blame for the financial crisis. One clear argument against this is the fact that we have been suffering from periodic financial crises for centuries. With the most recent one there were also several other contributing factors, such as the Democrats’ mass support of home ownership, new technologies and financial innovations.