To what extent does the Efficient Market Hypothesis (EMH) Explain the Global Financial Crisis?

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Introduction

It was previously assumed that economic investors and regulators (agents) utilised all available information and thus market prices were a reflection of this information with assets representing their fundamental value, encouraging the position that agents’ actions were rational. The 2007-2008 Global Financial Crisis (GFC) is posited to have originated from the notion that all available information was utilised, causing agents to fail to thoroughly investigate and confirm “the true values of publicly traded securities,” leading to a failure to register the presence of an asset price bubble preceding the GFC (Ball 2009).

This essay will use the notions of EMH to determine the extent to which they can explain the Global Financial Crisis using the US as a case study.

Efficient Market Hypothesis

Fama propounded EMH, in 1965, stating that provided all available information is used, market prices will reflect reasonably accurate approximations of the inherent present value of securities; the employment of this information would render agents’ actions rational. Ball expands on this by suggesting that competitive markets lead to costs falling in line with the employment of information.

The question proposed by EMH is thus, why did the GFC occur if agents are using every piece of information available to them and how does relying on the notions of EMH contribute to market crashes? Ball highlights a significant argument by suggesting that the revelation of new information leads market prices to drop because of re-evaluated expectations. In the case of the 2007-2008 GFC subprime mortgages were permitted and this led to asset price bubbles: an ignored feature of the market, thought to be a prominent cause of financ...

... middle of paper ...

...cmillan, 2007. http://web.mit.edu/alo/www/Papers/EMH_Final.pdf (accessed April 7, 2014).

Mishkin, Frederic S. Board of Governors of the Federal Reserve System, "How Should We Respond to Asset Price Bubbles?." Last modified May 15, 2008. Accessed April 12, 2014. http://www.federalreserve.gov/newsevents/speech/mishkin20080515a.htm.

Muth, John F. "Rational Expectations and the Theory of Price Movements." Econometrica. no. 3 (1961): 315-335. http://www.jstor.org/stable/1909635 (accessed April 6, 2014).

Trading Economics, "UNITED STATES GDP REVISED UP TO 2.6% IN Q4." Accessed April 10, 2014. http://www.tradingeconomics.com/united-states/gdp-growth.

United States Department of Labor: Bureau of Labor Statistics, "UNITED STATES GDP REVISED UP TO 2.6% IN Q4." Last modified April 11, 2014. Accessed April 11, 2014. Labor Force Statistics from the Current Population Survey.

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