Monday, November 02, 2009

EMH Is Wrong?

Modern economists are always criticized for mainly 2 hypotheses: (1) REH and (2) EMH. The reason is easy. These hypotheses seem to be fictional, not real.

(1) REH
Rational Expectation Hypothesis - It is a very important idea in modern macroeconomics and originated from John Muth. Shortly, it says that the economic equilibrium we reach is determined by what we "expect" for the future economic behavior. That means our economy is the mirror of our expectation.

Efficient Market Hypothesis - It is a very essential idea for modern financial theory and originated from Eugene Fama. Briefly, it states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low.

Many people claim that EMH is the main culprit of the Crisis, but Prof. Jeremy Siegel says in reply that the fact that automobiles today are safer than they were years ago does not mean that you can drive at 120 mph.

A small bump on the road, perhaps insignificant at lower speeds, will easily flip the best-engineered car. Our financial firms drove too fast, our central bank failed to stop them, and the housing deflation crashed the banks and the economy.

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