Answer to Question #160981 in Macroeconomics for hellen

Question

In a September 2009 article in the New York Times Magazine, the Nobel Laureate Paul Krugman wrote that “in short, the belief in efficient financial markets blinded many, if not most, economists to the emergence of the biggest financial bubble in history”. Evaluate the Efficient Market Hypothesis (EMH) using evidence. Explain whether you agree with Krugman’s analysis that the financial crisis of 2007-9 invalidated the EMH. 

Answer 1

The efficient market hypothesis is considered to be under consideration by professionals. Multiple reasons have driven its broad research. In an inefficient market, what is expected to be higher is a risk-weighted return. Both private and institutional investors, what is important to them is the market efficiency research field.

Market participants irrationality is a market efficiency contradiction, accordance to behavioral finance. The irrational behavior causes short – term variation in stock prices and long-term asset bubbles. Shiller (2003) argue that asset bubbles are evoked by the effect feedback. Comparing the active and passive portfolio is favoring the EMH. If managed actively portfolios fail to outsmart passive portfolios, market information is not profitable to be collected; thus, the market is efficient. Malkie (2011) state that profitable mutual funds in the short term did not remain profitable in an extended period. Fama (1988) state that the market line slope is more significant than it should be in practice.

I agree with analysis of Krugman’s that EMH was validated by 2007-9 financial crisis. EMH fails to explain stock prices in excess volatility, investor overreaction, asset bubbles, and seasonality returns. Market inefficiency is dependent on the size of the market and its maturity.