Why financial markets are inefficient
Roger E. A. Farmer 22 January 2013
The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. This column argues that market efficiency is extremely unlikely even without frictions or irrationality. Why? Because there are multiple equilibria, only one of which is Pareto efficient. For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice. This invalidates the first welfare theorem and the idea of financial market efficiency. Central banks should thus dampen excessive market fluctuations.
Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as:
Financial markets Macroeconomic policy
efficient market hypothesis, Finance, first welfare theorem, market fluctuations