The front page of today's Wall Street Journal has an article on the long-running debate between Chicago's own Eugene Fama and Richard Thaler, regarding how efficient markets really are. In case you don't know, the scorecard reads Fama: Pretty efficient; Thaler: Not that efficient.
As the article explains,
In its purest form, efficient-market theory holds that markets distill new information with lightning speed and provide the best possible estimate of the underlying value of listed companies. As a result trying to beat the market, even in the long term, is an exercise in futility because it adjusts so quickly to new information.
Behavioral economists argue that markets are imperfect because people often stray from rational decisions. The believe this behavior creates market breakdowns and also buying opportunities for savvy investors.
Of course, neither of the principles would cling to the most extreme forms of these positions until death did they part.
... Mr. Fama... says he's never believed in the pure form of the efficient-market theory
and
... despite his research on market inefficiencies, [Mr. Thaler] also concedes that "it is not easy to beat the market, and most people don't."
From the point of view of a policymaker, the question would be: Under what assumption about the way markets work would we be less likely to make significant mistakes? And as the article points out, it does matter.
Take for example, Social Security... President Bush has set a goal of partial privatization of Social security by allowing younger workers to put some of their payroll taxes into private saving accounts for their retirements.
In a study of Swedish efforts to privatize its retirement system, Mr. Thaler found that Swedish investors tended to pile into risky technology stocks and invested too heavily in domestic stocks. Investors had too many options, which limited their ability to make good decisions, Mr. Thaler concluded. He thinks U.S. reform, if it happens, should be less flexible.
This is an interesting ongoing debate, worth keeping track of.