Sunday, August 9, 2009

Efficient Markets Again

Paul Krugman reviews several books in the New York Times, especially Justin Fox's book, The Myth of the Rational Market. But I wonder if Krugman actually read his own article. He reviews the development of modern finance theory, and especially emphasizes efficient markets (EMH) and the capital asset pricing model, CAPM. He then argues that this is what created the financial crisis.
Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy.
Doesn't this seem strange? If Wall Street bought the ideas of the efficient markets hypothesis why would invest so much in complex trading strategies? If they believed CAPM, they would know that they could only earn more return by taking on more risk. Isn't it more correct to argue that they did not believe in the EMH and the CAPM?

P.S. Today, Falkenstein likes Krugmans review no more than I, and is much harsher.

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