The failure of the Efficient Markets Hypothesis is, perhaps, an even more significant outcome of the crisis than the end of the Great Moderation.

The EMH implies that, provided governments get prices right (avoiding distorting taxes, internalising externalities and so on) it’s impossible to improve on the allocation of investment capital generated by private markets. The converse doesn’t hold automatically. Even granting that private markets are subject to bubbles and fads, and that their investment decisions may not make sense in the light of publicly available information, it doesn’t necessarily follow that governments can do better. Still, for large scale infrastructure systems, the case for leaving investment planning as, in Keynes words ‘the by-product of the activities of a casino’, looks a lot weaker now than in did before this crisis. Of course, for anyone who cared to look, the ludicrous investment decisions made during the dotcom boom had already undermined the EMH.

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. I’ve written a more detailed version of this argument here here

For all my bitching and moaning, I believe the EMH gets it almost as close to right as possible; and when it doesn’t, I think the reasons it doesn’t have less to do with the fundamental chasm between rational and irrational behavior, but simple obfuscation. For instance: global warming, and the nations’ uniform lackluster response to it, is not a market failure anymore than a rained out baseball game is a baseball failure. Rather, the market never really got to have its say. If the externalities of energy consumption are so obscured that some people have no idea that they’re even there, well, you shouldn’t be surprised when there’s so much idiocy everywhere.

This happens whenever you isolate people from the consequences of their actions. Trust fund babies are fucked up weirdos because they’ve never had to earn a living and never had to deal with real people; the rules of the world, as they know it, are different from the rules of the world as we know it. Within their bizarro universe they are reasonable people; the problem is that their universe is a tiny subset of the larger universe. They’d all be just as fine and dandy as anyone else if the larger realities had been taken into account.

Is this just splitting hairs? I dunno. My point is that even in cases of “market failures” the first 80% of redress should be in making sure all the information required by the EMH is actually reflected in the market, not buried from ten levels of indirection in SEC filings, but right in front. A lot of people made some really, really stupid decisions because they honestly didn’t know any better. Fuck, if real estate gains twenty percent a year for the entire period of your awareness you’d be stupid not to buy in. You’re actually making a RATIONAL DECISION with the data you have.

And anyway, the market _is_ behaving efficiently, right now. Economic conditions were built on smoke and mirrors, and now they’re gone – that’s efficiency. If you find this sort of mega-efficiency to be too slow, or too clumsy, the first redress should be to reduce the grain of these giant market cycles. Give people the tools to be more rational and often times they will be. Creep carefully into the dangerous territory where the Government decides what’s the best economic policy, even a ‘hybrid’ policy, even one informed by behavioral- and neuro-economics.

(I wonder if I’ve ever written a post the legions of LSH readers have ever cared about less. Votes?)

Under questioning from Rep. Henry Waxman (D-Calif.), the committee chairman, Greenspan acknowledged that the failure of that expected self-regulation represented “a flaw in the model” he used to analyze economics. “I was going for 40 years or more on the perception that it was working well.”

Of course, this admission was roundly panned by Objectivists and their brethren in market fundamentalism, libertarians. And there’s the classic response that the guvm’nt is really the cause of all the market’s problems.This is how so much discussion of the markets goes, with free-market zealots expressing their faith in the omnipotence of markets, and market-haters making arguments that ignore the success of markets in dealing with many of the problems that face us today.

What bothers me is that there really is a lot of science being done on the kind of decisions real human beings make in economic matters, which is largely ignored in the media’s analysis. Behavioral Economics and Neuroeconomics are becoming well developed fields, and recent books (like Michael Shermer’s The Mind of The Market) provide accessible and fascinating analysis of these experiments (though that book has a baffling ending where Shermer relapses completely).

The author of another such book, Predictably Irrational, explains this in a way I though was really intuitive in this post. The post is short, so rather than explain it I’ll just inline it here:

I always found the appeal to the market gods a bit odd. Why would the market fix mistakes instead of aggravating them?  When the Chicago economists sometimes (reluctantly) admit that people make mistakes, they claim that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that, instead, people will often make the same mistake, and the individual mistakes can aggregate in the market.  Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse.  It is not as if some people made one kind of mistake and others made another kind.  It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now.

A statement like this can enhance your understanding, be falsified, etc. Either way, it isn’t simply an assertion of faith or hatred. It’s a nuanced view, which is what the truth almost always is, especially when dealing with a complex emergent system like the market. Why aren’t we hearing more from the behavioral and neuro- economics people during this downturn?