Efficient Market Theory and the Recent Financial Crisis

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The world economy in 2008-2009 has passed through the most severe economic downturn since World War II. This global recession was preceded by the collapse of some of the largest financial institutions in the world.

The financial turmoil caused by these dislocations disrupted world credit markets and precipitated a sharp global economic contraction.

This financial meltdown was caused by the downward movement in real estate prices and coincident decline in mortgage and other real-estate related securities that were tied to housing prices. The meltdown followed a dramatic misestimation of the risk of these securities, many of which were mistakenly rated AAA by the leading rating agencies. This misestimation led to an overleveraging these assets by many financial institutions which, when prices fell, caused severe liquidity problems which drove many firms near to or into bankruptcy.

Many have described the recent crisis as the death knell of the academic notion of “efficient markets.” Financial journalist and best-selling author Roger Lowenstein stated: “The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.”2 In a similar vein, the highly respected money manager and financial analyst Jeremy Grantham wrote in his quarterly letter last January: “The incredibly inaccurate efficient market theory [caused] a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments [that] led to our current plight.”