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How Did Financial-Crisis-Based Criticisms of Market Efficiency Get It So Wrong?

Ariane Szafarz

No 10-01.RS., DULBEA Working Papers from ULB -- Universite Libre de Bruxelles

Abstract: Criticizing the Efficient Market Hypothesis (EMH) on the basis of highly volatile asset prices is conceptually wrong as efficiency is about rationality and information, not about stability. Speculative bubbles are compatible with rational valuation, and hence with market efficiency. As rational expectations are auto-referential, multiple solutions are a natural outcome. This paper attributes the prevalent confusion between bubbles and irrationality to the bad reputation of multiple-solution models often considered as underspecified. It argues that multiple solutions rather represent an opportunity to economists by bringing theoretically sound degrees of freedom to empirical implementation. Moreover, the recognition of multiple price dynamics compatible with market efficiency thwarts irrationality-based theories and, as such, is a valuable asset largely underestimated by the profession.

Keywords: Efficient Markets; Multiple Solutions; Rational Expectations; Speculative Bubbles; Volatility. (search for similar items in EconPapers)
JEL-codes: G14 G12 B41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-hpe
Date: 2010
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