Efficient marlcets are the natural extension of the last 200 years of economic theory. Here at last was a place to take a stand, a stand that would once and for all establish that people behaved in the rational manner economists have assumed for centuries. Demonstrating that people actually behaved this way in financial markets would be almost akin to discovering the Holy Grail of economics.

It is not su rising then that the original "evidence" by Fama, Blume, Jensen, Scholes, et al., that markets were efficient was enthusiastically greeted by economists, perhaps nowhere more so than at the University of Chicago, one of the renowned bastions of laissez-faire. Equally logical was that Chicago became the intellectual heart of this dynamic new research.

Market economists threw down the gauntlet. So deep was their conviction that these theories would usher in the golden age of markets, if not economics, that they were convinced the statistics would bear them out.

As one academic noted: "You can see why the idea [of perfectly knowledgeable investors in the stock market] is intriguing. Where else can the economist find the ideal of the perfect market? Here is a place to take a stand if there is such a place."

Chapter 14 showed that MPT, the model built to create and test strategies based on efficient markets (anchored on the direct relationship between a stocks volatility and its expected retum) had gone down in flames. Investors do not measure risk in the way the theorists expected. The rigorous risk measurements they assumed investors undertook were so complex and required such mathematical ability as to be almost ludicrous.

Still such a risk measure is essential to the concept of efficient markets. Risk, as the researchers defined it, is die core of MPT thinking. Fama and French, for example, state that "If stocks are priced rationally, systematic differences in average retums are due to differences in risk. Thus with rational pricing, size [of company] and book to market must proxy for sensitivity to common risk factors in returns." Fama thus regards the superior performance of contrarian sti-ategies as compensation for investors taking on additional risk. (However, said risk remains undiscovered, even by sophisticated academics ... even by Fama himself.)

One wonders why Professor Fama or other investigators just dont go out and ask one or two typical investors who supposedly use these complex risk calculations, exactly how they figure them out. But no, markets are efficient because investors are risk averse, and they are risk averse because markets are efficient. This is the hole that the proud efficient market researchers have dug for themselves.

The Crisis of Modern Economics

The most important reason researchers erred so badly on risk measurement is the manner in which EMH and most other economic investigators conduct their research. Since the Second World War the social sciences have attempted to become as rigorous as the physical sciences. No discipline has put more effort into this goal than economics. Starting about fifty years ago, economists held out high hopes that through mathematics they could make the dismal science as predictable as Einsteins theory of relativity or Keplers laws of planetary motion. Nobel laureate Paul Samuelson, then a young professor of economics at MIT, was the first to integrate the techniques of differential equations, which had met with such success in physics, into a structured approach which could be used to study virtually any economic problem.

The key assumpUon was rarionality: for a firm it meant maximizing profits, for an individual maximizing his or her economic desires. Radonal behavior is the bedrock of Samuelsons work. This dubious platform allowed the economist to merrily build the most complex mathematical models. Economics could now be converted into a precise physical science.

The great majority of economic research gravitated in this direction, despite the warnings of some of the important economic thinkers of the past. John Maynard Keynes, for example, was trained as a mathematician but refused to build his classic theory on unrealistic assumptions. Like his teacher, the great Victorian economist Alfred Marshall, Keynes believed economics was a branch of logic, not a pseudo-natural science.

How strong is tiie evidence tiiat supports EMH? From what weve seen, this revolutionary theory seems to have been bulk on the flimsiest of foundations-unkind critics might say a house of cards. The core of the hypothesis-the theory of the rational measurement of risk-was simply an untested assumption of financial academics, which was necessary to bind investment theory to economics. Yet for EMH to be correct it was essential that investors did measure risk in this way. The academics willed it to be true-and continue to do so today.

As noted, many EMH researchers are still looking for the market equivalent of the Holy Grail-proof that investors are risk-averse as they have defined it. Though it almost boggles the mind that some of the worlds finest economists have trapped themselves in such a logically indefensible position, it follows directly from the economic research models followed in the postwar period.

Marshall himself wrote that most economic phenomena do not lend themselves to mathematical equations, and warned against the danger of falling into the trap of overemphasizing die economic elements diat could be most easily quantified.

The Samuelson revolution, however, widi its emphasis on complex quantification parroting the physical sciences, came to totally dominate economics in the postwar period. Mathematics, which pre-Samuelson was a valuable but subordinate aid to reality-based assumptions, now rules economics. Good ideas are often ignored by economists simply because they are not written down in pages of highly complex statistical formulas, or dont employ equations using most of the letters of die Greek alphabet. The vast amount of research published in the academic journals contains minuscule additions to economic thinking, but is dressed in sophisticated mathematical models. Bad ideas planted in deep math tend to endure, even when the assumptions are questionable and evidence strongly contradicts the conclusions.

Economic ideas and principles once understood by educated readers are now unfadiomable to all but the most highly trained madiematical researchers. This would be well and good if economics had achieved die predictability of a physical science.

But without realistic assumptions the dismal science has been broken down rather than rejuvenated by mathematics. As John Cassidy points out in an excellent article in The New Yorker, complex new madiematical theories such as those of Robert Lucas, a Nobel Prize winner from the University of Chicago, while causing a generation of novice economists to build ever more complex models, are discredited in the end, with no agreement on what should replace them.

Lucass work concluded that the Federal Reserve should not actively guide the economy, but only increase the money supply at a constant rate. The research came under theoretical attack, again because at the core of Lucass complex mathematical formulas were untenable simple assumptions such as supply always equals demand in all markets. (If this were true we could not have unemployment-the supply of workers would never exceed the demand for them.) Once the supply-demand assumption is dropped, few of Lucass conclusions hold up. Commenting on the impracticality of Lucass work, Joseph Stiglitz, then chairman of the Presidents Council of Economic Advisers, said, "You cant begin with the assumption of full employment when the President is worried about jobs-not only this President, but any President."

Economics, traditionally one of the most important of the social sciences, has suffered a self-inflicted decline. Not all are unaware of this. In 1996 die Nobel Prize for economics was awarded to two men.