This is me back in 2010:
The EMH is approximately true; indeed it’s almost impossible for me to imagine any other model of financial markets. But it’s not precisely true, again, just as you’d expect. After all, if the EMH were perfectly true then no one would have any incentive to estimate fundamental values. We know people are imperfect and hence that any real world human institution, including markets, will be at least slightly imperfect.
A smart person like Eugene Fama should have been able to come up with both the EMH, and its limits, by just sitting in a room and thinking. Much as David Hume got the QTM by imagining what would happen if everyone in England woke up one morning with twice as much gold in their purses. Or Fisher’s theory of inflation and nominal interest rates. Or Cassel’s purchasing power parity. Or Friedman/Phelps’ natural rate hypothesis. Or Muth and rational expectations. Certain ideas are simply logical, and that’s why I have no doubt that despite all those economists on the left arguing the EMH has been discredited, it will still be taught in every top econ/finance grad program 100 years from now, whereas fiscal stimulus will be long gone from macro textbooks.
PS. Why will fiscal stimulus be gone? Because even Krugman admits it only makes sense at the zero bound. And we are rushing headlong into a world of all electronic money–probably within 50 years. There is no zero lower bound with electronic money, and hence the Taylor Rule is all you need. Old Keynesian economics will vanish, leaving only new Keynesianism.
And here’s my doppelganger Noah Smith 4 years later:
Now, the analogy between the EMH and Newton’s Laws is far from perfect. Newton’s Laws are wrong in a finite set of ways, under conditions that are predictable and well-known. The EMH, in contrast, is wrong in an infinite number of ways, and the set of the most important ways in which it’s wrong is constantly changing, as old anomalies are traded away and new ones crop up. Also, the EMH is actually a family of hypotheses, since you need a model of risk to specify it properly.
But like Newton’s Laws, the EMH is deep and fundamental. If you went through a wormhole and visited an advanced alien civilization, what would they think about financial markets? Chances are, they wouldn’t use the Capital Asset Pricing Model, or the Fama-French 3-Factor Model, or the Shiller CAPE. But I bet they would have some version of the Efficient Market Hypothesis.
This is because the EMH doesn’t emerge from any peculiarity of the way our market system is set up, or the way human beings behave. The EMH comes from something much deeper than that, something that probably has to do with information theory. It comes from the fact that when you exploit information to make a profit in a financial market, you decrease the amount that others can exploit that information. In other words, the financial value of information gets used up. That sounds simple and obvious, but so are the principles that give rise to Newton’s Laws.
In any case, the anomalies that make the EMH not quite right may also have deep explanations, but we don’t know what those are yet. When we do, that will be a big advance in finance theory. But the EMH will still be the jumping-off point for any theory of financial markets, on this planet or any other. It will always be wrong, but never useless.
Noah reached this insight 4 years after I did. But don’t be fooled, he’s much more than 4 years younger than me. He reached enlightenment at a younger age because he’s also much smarter than me.