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One might think that the whole financial market-efficiency project should have been rejected out of hand because it is founded on a large set of unrealistic assumptions about how financial markets work. Yet not only is it still the dominant theory of financial markets, Nobel Prizes have been awarded to its originators. Why would an academic profession sanction the use of theories based on such unrealistic assumptions? The answer given by proponents of efficient financial markets theory is that the economics profession relies on the theory of “positivism” associated with Milton Friedman as its guide to the acceptance and rejection of theoretical propositions. Friedman’s positivism states that the realism of assumptions does not matter: it has no relation whatever to the acceptability of a theory or its derived hypotheses. As Friedman put it, “[T]ruly important and significant hypotheses will be found to have assumptions that are wildly inaccurate descriptive representations of reality.” The only acceptable test of a theory “is comparison of its predictions with experience.”
There are at least three serious problems with this method. First, if patently false assumptions are adopted, as in efficient financial market theory, and impeccable logic is used to deduce hypotheses from them, they cannot—as a matter of logic—be accurate reflections of reality. Fairy-tale assumptions can only generate fairy-tale hypotheses.
Third, when positivist economists insist that econometric “prediction” is the sole judge of the acceptability of a theory, they put the entire burden of proof on econometric tests. But when the preponderance of such tests turns out to be inconsistent with their favorite theory, they never reject the theory, as their methodology says they must.
Mr. Fama’s seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006.
Why would an academic profession adopt a methodology such as positivism that supports theories that are based on unrealistic assumptions?
After all, there is an obvious alternative—begin with a realistic assumption set and use it to derive realistic hypotheses about the behavior of financial markets. This is the method used by Keynes and Minsky to show that financial markets have no efficiency properties and are properly thought of as gambling casinos.
The answer is that the economics profession is committed ideologically to a defense of the proposition that financial markets are efficient, yet it is impossible to derive this proposition from a realistic assumption set.
Thus, the profession had no choice but to adopt a positivist methodology that sanctioned the use of even absurdly unrealistic assumptions in theory construction. Since realistic assumptions lead to theories that show the strengths, but also the myriad dangers and failures of unregulated capitalism revealed in the historical record, they had to be replaced by the large number of absurd assumptions required to sustain support for economists’ inherent belief that unregulated or lightly regulated markets create the best of all possible worlds, maximizing both economic efficiency and individual liberty. Positivism is the magic that makes it possible to construct a “scientific” defense of the proposition that free-market capitalism has no serious flaws and dangers.