Heterodox Analysis of Financial Crisis and Reform

Heterodox Analysis of Financial Crisis and Reform

History, Politics and Economics

Edited by Joëlle Leclaire, Tae-Hee Jo and Jane Knodell

Though the worst of the financial crisis of 2008 has, with hope, ebbed, it has forever changed the economy in the United States and throughout the rest of the world. Using the financial and economic crisis as a catalyst, this volume examines how to better regulate the financial system and what to expect in the future if no steps are made toward reform. This book lays the foundation for those steps by providing concrete ideas that will push policy in the direction of jobs growth and widespread prosperity.

Chapter 5: The Instability of Financial Markets: A Critique of Efficient Markets Theory

Robert E. Prasch

Subjects: economics and finance, financial economics and regulation, institutional economics, post-keynesian economics


Robert E. Prasch* A long tradition in economic thought – one that persisted through the Classical, Neoclassical and Neoclassical Synthesis schools – argued that markets in general, and financial markets in particular, self-stabilize. Rarely was it asked if a ‘natural’ or stable equilibrium price existed, or whether a market system operating without constraint could or would adjust to achieve it. The recent New Classical school excepted, most economists did allow that a free market system could be periodically out of equilibrium, but this was readily explained by the existence of ‘government interference,’ ‘exogenous shocks’ or ‘adjustment lags.’ The latter being, notoriously, ‘long and variable.’ THE THEORY OF EFFICIENT MARKETS That was then, but this is now. By the latter 1970s the mainstream of macroeconomists and virtually all finance economists had come to believe that – by contrast to the markets for goods, services and labor – financial markets were highly ‘efficient.’ This idea came to be formalized as the ‘theory of efficient markets.’ Channeling claims made earlier by Friedrich von Hayek and the Austrian School of economists, its core notion was that relative prices are, in effect, highly efficient indices reflecting the underlying conditions, trends and expectations in existence at any given moment (Hayek, 1945). The logic was that in a free market relative prices arise from the interaction of a large number of interested parties making (or not making) trades reflecting their own talents, resources, constraints, needs and available knowledge, with the latter including expectations of future conditions. Stated simply the theory...

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