Tuesday, April 20, 2010

With No Power, Comes No Responsibility: Efficient Market’s Role in Regulation (part 1)

“With no power, comes no responsibility”. The catchphrase from the movie "Kick-Ass" seems to describe the current state of financial regulation rather well. Unfortunately, the larger Conversation on financial reform has been anything but kick ass. We have a tragedy of the commons scenario where every regulator, policy maker, academic and practitioner has joined the blame game.

No. It is not their fault. After all, people merely followed what the intellectual luminaries preached, which made the Efficient Market Hypothesis (EMH) one of the “best selling” ideas of all time. By assuming that prices reflect all known information, the EMH is convenient, user-friendly, and rationalizes laziness as an appropriate policy. It is a hypothesis that can never be wrong (cannot be disproved). The Efficient Market Hypothesis had us at hello.

The EMH truly liberated the people. It guided policy makers to pursue deregulation, freed regulators from their jobs, and saved practitioners from performing in-depth analysis. With free time on everyone’s hands, creativity reigned. Complex derivatives such as CDOn proliferated and the EMH encouraged the industry to adopt a “sell first, ask later” motto. Let the market figure out how to price them, says the EMH. Financial innovation quickly transcended the industry. If the EMH were a person, the Nobel Peace prize would be its to lose.

We find ourselves in a very different world today. The EMH is now being crucified as the elegant theory that caused the financial crisis. As Krugman suggests, people mistook beauty for truth and economists everywhere climbed aboard the EMH-Titanic that was destined to hit the iceberg.

However, the fault was never with the theory per se. The EMH is silent on its ability to explain bubbles and crashes, and offers no real use to policy making. No power. No responsibility.

What we need today is a more powerful theory to guide policy and put responsibility back in the hands of the regulators. We do not need more debates on the financial reform, which have done nothing but amplify confusion. Without coherence, there is no reform. And we are running out of time.

In part two of this series, I propose a Cyclical Efficient Market Hypothesis (C-EMH) that integrates viewpoints from psychology and quantitative finance to complete the EMH. The result is a model that is useful to guide policy making and regulation.

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