Question

The recent financial crisis has spawned an impressive outpouring of blame. For example, market strategies Jeremy Grantham called the EMH "responsible for the current financial crisis". The reasoning is following: Efficient Market Hypothesis (EMH) asserts market prices reflect all available information, so the market participants felt little need to verify true values of financial assets and hence failed to detect the asset bubbles. The Turner Review, issued by U.K.'s market regulator (Financial Services Authority) in 2009, also shares a similar view. Is EMH responsible for asset bubbles and financial crisis? Briefly evaluate this argument.

Answer 1

Putting the blame of asset bubble or financial crisis on any theory certainly would not be the appropriate thing to do. The asset bubbles and financial crisis are more the outcome of mismanagement of risk, incomplete understanding of the financial products like derivatives and human nature to indulge in excess greed and fear.

Efficient market hypothesis states that asset price in the market reflect all available Information. Now if someone is blindly using this theory then they would certainly blame EMH for these bubbles and crisis. In real world no theory can completely describe a situation because every theory is based on certain assumption and that assumption has to be held in the real world all the time which is not practical.

Although, these theories can be blamed partially for the reason that they Induce people to behave in a certain way. Housing bubble was more a result of providing cheap money to people whose credit standing were not justifiable. People started taking loans and buying houses and house prices kept on rising and people believed that this rise will continue forever. When the time came to repay the loan, people defaulted and financial institution were left with large number of house but little cash. Similarly financial crisis like recession should be blamed on human nature to indulge in excess greed or fear.