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The Student News Site of Stony Brook University

The Statesman

The Student News Site of Stony Brook University

The Statesman

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    Efficient Market Hypothesis

    The efficient market hypothesis states that the prices on traded assets reflect the all the information completely available to the market. In other words, there is no person or government that could set prices more efficiently than a free market, because no single person or even group of people could possibly know all the information required to set an accurate price. Therefore, when stock in a given company is traded at a certain price, it is that price, and only that price, which accurately represents the worth of that company at the current time with the current information.

    However, this also means that the price only reflects a company’s current value and not any future value. It is almost impossible to predict market trends, especially in the long term. This is a well known fact to long term investment strategists but is apparently unheard of by market regulators.

    Financial markets are regulated by government, Securities and Exchange Commission (SEC), an independent federal agency, the Federal Reserve, an independent central bank with a government appointed board, and indirectly by legislation. However, just like an investor can only gamble upon the action of the market, a regulator can only respond to current market information.

    Therefore, when the public demands the government impose regulation in order to prevent future economic crises, regulators can only act on current market information. Tomorrow’s problems may be completely unstoppable by current regulation, and may even be caused by it.

    For example, in the early 2000s, the Federal Reserve had a policy of keeping the federal funds interest rates low, to expand credit availability to housing developers. Government, in turn, used regulation to convince Fannie Mae, et. al to issue lots of sub-prime mortgages, so people would buy those houses. This caused housing prices to soar, which was great for the housing market and banks, until people stopped mailing in their mortgages payments and stopped buying up all the newly-built Florida condos. This resulted in a lot of companies owing other companies money and resulting housing bubble burst and investment bank bankruptcies.

    If the government wasn’t able to predict this, given the fact that business cycle bubbles caused by government policy is a common occurrence, what makes us think that current regulatory policy will be able to take care of tomorrow’s unknowable problems?

    Another example of past regulation causing today’s problem is the the fair value accounting laws pushed by the SEC after the Enron scandal, caused by accounting fraud. The goal in assigning a “fair value” to an asset, rather than a market value, is that a “fair value” tends to be a more arbitrary assessment of the value of goods than market value, which takes into all currently known information into consideration when determining prices. Additionally, during times of market volatility, assets priced at “fair value,” which isn’t considerate of the historic strength of the asset, will drop quickly, causing a massive sell off of that asset at lower and lower prices. This effect was seen with value of mortgage-backed security bonds, which played a role in the current financial crises.

    It’s easy for a public to demand more regulation during a crises, but its quite another to expect regulators to act intelligently during a crises. If the market value of an asset reflects the best known available information at the time, then if a stock is valued low it indicates that the company is not as valuable. Should government regulators, therefore, be trying to stop activities that results in the company’s own devaluation? Especially considering that regulators will only be able to act after said devaluation has already occurred, and effects of the regulation are not assuredly safe.

    If we call into question the activities of human regulators, we see that government regulation violates an important principle of the efficient market hypothesis. No person can predict the future activities of the market better than the market can, which is to say, not at all. Therefore, asset values determined by the market reflect all the information available, information that no person or government entity could fully acquire and understand. To trust a regulator to make a good decision based on market information, better than the financial market itself, is a ludicrous, and dangerous, notion.

    In times of uncertainty, the desire to take an active and regulatory role is strong. However, we must tread carefully when dealing with the financial markets the global economy is based on. It’s easy to imagine the effect that not stepping in will have — bankrupted companies, unemployment, market downturn. On the other hand, markets can recover when smarter entrepreneurs step in to take the place of those who got greedy and made bad decisions. It’s not so easy to imagine the effect that propping up and nationalizing these institutions will have. We could be creating tomorrow’s problems in our attempts to fix yesterday’s bad regulation, simply because we’d rather trust an imperfect regulator than an all-knowing market.

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