The efficient markets thesis is that the market makes complete use of all relevant information, and the “proof” is roughly that in a perfectly competitive market among perfectly rational agents prices invariably and instantaneously reflects all agents’ real beliefs and real desires. Any one who knows anything that can make him or her money acts on it—buys or sells—and that signal is picked up by every one else, who also acts on it, thus preventing any one from making excess profits—rents--long-term.
The first thing a philosopher notes about this notion is that since most people have false beliefs, especially about the future, an efficient market doesn’t internalize knowledge, but only beliefs. If they are mostly false, then the market isn’t efficient at internalizing (correct) information, it’s efficient at internalizing mostly false beliefs. If false beliefs are normally distributed around the truth, then they’ll cancel out and the proof of a probabilistic version of the efficient markets theorem will go through—market prices reflect the truth most of the time. Too bad false beliefs don’t always take on this tractable distribution. Even worse, when enough people notice the skewed distribution of false beliefs, they can make rents, as the markets crash. This is what Cochrane seems to think can't happen. How many times will it have to happen for the Chicago School to give up the efficient markets hypothesis?
When I read this, I was immediately reminded of a talk I accidentally attended (it was in a modeling session, and came between the two talks I was actually there to hear) a few years ago. Unfortunately, I don't remember the speaker's or his co-authors' names, so I can't credit them, and I don't even remember the specifics of the model, but I do remember what the model showed. What the modelers did, basically, was have a bunch of individual actors behave irrationally (i.e., sub-optimally), and look at the behavior of the system as a whole and see if it was irrational in a corresponding way. The conclusion they came to, after running the thing a whole bunch of times, as modelers are wont to do, was that even when most of the actors behave irrationally, the system as a whole results in a surprisingly rational end state.
Now, this doesn't mean that Rosenburg's wrong in the above-quoted passage. For one, under at least some views of rationality, one can have false beliefs and still behave rationally based on those beliefs. So rationality does not necessarily mean efficiency, especially to a philosopher (which Rosenburg is). And it is one model, presented at a conference by people whose names I can't even remember, after all. But it does make me wonder, and I'm not an economist so this may be a long-ago answered question, whether the move from recognizing that many, if not most actors in a system like the market have (mostly) false beliefs to the position that the behavior of the system as a whole will be inefficient is a logical necessity. Specifically, if people behave rationally, but based on false beliefs (which, to a naive modeler would be equivalent to irrational behavior), or behave sub-optimally in general, does this necessarily doom the system (market) to irrationality? On the surface it seems obvious that it does, but as science has often shown, surface appearances can be deceiving, and the model the speaker presented was designed to show that this particular appearance may in fact be so.
I don't mean any of this as a defense of the efficient market hypothesis. Again, I'm not an economist, but from what I little I do know of economics, and of the recent crisis, it seems pretty clear that the EMH has been empirically falsified. But an interesting question, particularly when picking up the pieces of economics and rebuilding it, is why it failed, and if we simply assume that it's because people have false beliefs, or because people behave sub-optimally (i.e., irrationally), and that this therefore dooms the system to behave sub-optimally, we may be missing other possible explanations. I know EMH supporters tend to assume that actors are rational, but what I'm asking, I suppose, is whether those trying to figure out why the market hasn't been efficient need to treat that assumption as the only way to arrive at the concept of an efficient market, particularly when we're trying to figure out why markets aren't, in fact, all that efficient. Theories, after all, didn't create the crisis (even if acting in accordance with them facilitated it), so we can't just address the theories that people actually hold when trying to answer practical questions and, when we've shown that a theory's reasoning is wrong, be convinced that we've already shown why its conclusions are wrong.
In other words, as with most questions, this seems like an empirical one.
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