Elgar Financial Law series
Chapter 4: Minsky and the Financial Instability Hypothesis: implications for market efficiency
The previous chapter explained the inherent problems associated with the traditional interpretation of financial market and financial system behaviour. The theories that underpin current regulation of securities markets reflect the view that capitalist systems are ‘equilibrium seeking’ and business cycles and asset swings are the product of exogenous shocks to market processes. The logical policy extension to this position is that regulation of financial markets or of companies operating within the system is futile as all currently known liabilities and risks are incorporated into market prices and nobody can anticipate an exogenous shock. However, on the basis of the discussions in the previous chapter concerning market inefficiency, it is clear that there are serious theoretical and empirical challenges to the EMH. Studies, particularly by behavioural finance scholars, have identified several market phenomena which are inconsistent with the EMH. Some of these are rather idiosyncratic, and may only undermine market efficiency in certain, limited circumstances. However, many are pervasive in financial markets, and may cause catastrophic damage if left unchecked, particularly bubbles in securities and asset markets. Further, the structural obstacles to the correction of mispricing are significant. When arbitraging a market is too costly – or impossible – to perform, significant mis-valuations may persist for protracted periods. However as noted in the previous chapter, behavioural finance and complexity theories themselves suffer from practical limitations and, by their very nature, are not adept at providing regulators with a basis for designing regulatory systems.
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