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The ongoing financial kerfuffle is wreaking all sorts of havoc, but the damage has been particularly acute for the perceived legitimacy of the financial industries. The crisis has led to a torrent of criticism which accuses Big Finance of gambling with our savings, handing out bloated bonuses, and generally being a disease upon mankind. A lot of this is misdirected populist rage, but some of it is well-deserved. In fact, I think that this rage will prove useful if it leads to a greater awareness - and criticism - of the underlying logic of the tools used by Big Finance. Here's why:

Much of modern financial economics is based upon a set of assumptions that can be broadly labeled the efficient markets hypothesis (EMH). While not universal, the EMH forms the core of most financial modeling and is the foundation of a great deal of wealth creation in the last couple of decades - at least, it was. The three basic assumptions of the EMH are:

1. markets allocate resources most efficiently
2. liberalized markets will enhance the overall welfare of society, and
3. given the opportunity, market actors will converge on the "correct" economic outcome

As Tyler Cowen explains in an essay on economists and rationality, the EMH comes in a variety of flavours. Weaker versions of the theory claim that rational stock picking will not on average outperform the market because the market already incorporates all the relevant information about the value of companies into the stock price. In other words, it's very hard to beat the market averages, unless you're very lucky or Bernie Madoff (too soon?).

Stronger versions of the theory claim that market prices accurately reflect the fundamental values of corporations and thus cannot be improved upon. In other words, when a share in Company X is worth $50, that price is based upon all the available information about Company X. And if the price of a share in Company X is worth $0.50 the next day, that's because investors responded (rationally!) to new information, nothing more. Even though nobody actually believes that ALL investors are rational, it is assumed that capital markets are close enough to the ideal to allow rational investors to prevail.

The EMH is used in academia primarily for modeling discipline, but the theory also underpins many of the models and tools used by Big Finance. Unfortunately, it appears as though the beautiful simplicity offered by models of market rationality can lead to some pretty disastrous consequences. For example, Felix Salmon has a great piece on the formula that killed Wall Street. The article tells the story of how a mathematical model was developed which appeared to take the risk out of pricing risk. The formula explicitly assumed a strong version of the EMH and it spread like "a highly-infectious thought virus." All of the qualifications about the limits of model were buried under the stacks of money that this little formula was earning for financial executives. This is definitely worth reading.

But what's the problem with EMH, anyway? For one thing, it's tautological: how do you define the correct, most efficient economic outcome? If the answer is: "the outcome achieved by perfect markets," you're back where you started. The EMH appears to simultaneously assume a) a non-determined process driven by human choice, and b) that this spontaneous process is working towards some final end which is somehow "correct." Willem Buiter puts it more colourfully, as usual:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time - a God-like father figure - who makes sure that nothing untoward happens with long term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.
What this shows, not for the first time, is that models of the economy that incorporate the EMH - and this includes the complete markets core of the New Classical and New Keynesian macroeconomics - are not models of decentralised market economies, but models of a centrally planned economy.

Put that in your efficient markets pipe and smoke it! Whether the fallout from the financial crisis will shift the balance towards more behavioural models of economics remains to be seen. At the very least, the crisis has forced a critical re-examination of the assumptions underlying modern finance; a re-assessment of what we thought we knew. That can only be a healthy thing.

(photo of the friendly auctioneer at the end of time from Wonder's photostream)