What’s Efficient About Efficient Capital Markets?

I got a chance to speak last week on a panel at the American Philosophical Association and I’d hoped to end up speaking more than I actually did about economists’ bad habit of smuggling normative concepts into their analytic statements with the so-called Efficient Markets Hypothesis being an excellent example. Jodi Beggs recently found a $10 bill on the sidewalk (besting my own run-in with a $5 bill) which naturally led to some ruminations on EMH:

[F]or example, the efficient markets hypothesis postulates that consistent excess returns in financial markets (i.e. free money) are impossible because market prices reflect all available information. The rationale behind the efficient markets hypothesis is that there are plenty of people and firms (hedge funds, etc.) just waiting to take advantage of any mispricings in the market, and capitalizing on these opportunities tends to adjust prices such that the opportunities go away.

Clearly one question people can and do ask about EMH is whether this is an accurate characterization of how major financial markets work. But another question that I think people are actually more interested in is whether or not “efficient” is the word we want to use to describe this level of capital market volatility:

What we have here is a comparison of the year-on-year growth in the very broad Wilshire 5000 Total Returns stock index with year-on-year growth in gross domestic product, using nominal GDP since stock indexes are denominated in nominal terms. GDP almost never declines and never grows by more than 20 percent. The value of America’s publicly traded stocks, by contrast, does both regularly even though there’s no way the outlook for business as a whole can diverge that much from the state of the overall economy. Now that observation doesn’t contradict the thesis that if there were some obvious way to make money off the excess volatility, that money-making strategy would end up pricing the volatility away. Still, as a point about language and values I would say that an “efficient” capital market would not be prone to these constant bouts of excessive optimism and panic. This doesn’t look like an especially efficient way to conduct the socially important function of pricing and allocating capital.