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Why financial markets are inefficient

The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. This column argues that market efficiency is extremely unlikely even without frictions or irrationality. Why? Because there are multiple equilibria, only one of which is Pareto efficient. For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice. This invalidates the first welfare theorem and the idea of financial market efficiency. Central banks should thus dampen excessive market fluctuations.

Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as:

  • ‘No free lunch’, what economists refer to as ‘informational efficiency’;
  • ‘The price is right’, what economists refer to as ‘Pareto efficiency’.

My recent research with Carine Nourry and Alain Venditti argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are really no reasons for believing that this will lead to Pareto efficiency, except, perhaps, by chance (Farmer, Nourry, Venditti 2012).

In separate work, I look at the policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive fluctuations in the financial markets (Farmer 2012b). These are strong and polarising claims. They are not made lightly.

Not irrationality, frictions, sticky prices nor credit constraints

Some economists will be sympathetic to my arguments because they believe that financial markets experience substantial frictions. For example, it is frequently argued that agents are irrational, households are borrowing constrained or prices are sticky. Although there may be some truth to all of these claims, my argument for direct central bank intervention in the financial markets does not rest on any of these alleged market imperfections.

Other readers of this piece will wish to challenge my view based on the assertion that competitive financial markets must necessarily lead to outcomes that cannot be improved upon by government intervention of any kind. That assertion has been formalised in the first welfare theorem of economics that is taught to every first-year economics graduate student.

The first welfare theorem provides conditions under which free trade in competitive markets leads to a Pareto efficient outcome, a situation where there is no way of reallocating resources that makes one person better off without making someone else worse off. In my work with Nourry and Venditti (Farmer, Nourry, Venditti 2012), we show why the conditions that are necessary for the theorem to hold do not characterise the real world.

We make some strong but standard assumptions:

  • Households are rational and plan for the infinite future;
  • They have rational expectations of all future prices;
  • There are complete financial markets in the sense that all living agents are free to make trades contingent on any future observable event;
  • No agent is big enough to influence prices.

Crucially, in our model, there are at least two types of people who discount the future at different rates; patient and impatient agents. We show that, even when both types share common beliefs, the belief itself can independently influence what occurs. This follows an important idea originating at the University of Pennsylvania in the 1980s, what David Cass and Karl Shell (1983) call ‘sunspots’, or what Costas Azariadis (1981) refers to as a ‘self-fulfilling prophecy’1.

The first welfare theorem, birth and death

What could possibly go wrong when agents are rational, hold rational expectations, there are no frictions, and markets are complete? Well, the first welfare theorem does not account for the fact that people die and new people are born. In our world:

  • Patient and impatient agents each recognise that the financial markets are fickle and that the value of the stock market could rise or fall;
  • If the markets boom then the patient savers, feeling wealthier, will lend more to the impatient borrowers;
  • If the markets crash, then the savers will recall their loans, made in better times.

But in our model environment, booms and crashes occur simply as a consequence of the animal spirits of market participants. Why should we care if there are big movements in the asset markets? After all, the borrowers and lenders are rational and they have made bets with each other in full knowledge that these large asset movements might occur.

  • The problem is that the next generation is unable to insure against swings in wealth that have a big influence on their lives.

Steve Davis and Till von Wachter (2011) have shown that the present value of lifetime income of new entrants to the labour market can differ substantially depending on whether their first job occurs in a boom or a recession. In our model, the lifetime income of the young can differ by as much as 20% across booms and slumps.

Given the choice, the young agents in our model would prefer to avoid the risk of a 20% variation in lifetime wealth. There is a feasible way of allocating resources that would insure them against this risk, but financial markets cannot achieve this allocation, except by chance. The inability of our children to trade in prenatal financial markets is sufficient to invalidate the first welfare theorem of economics.

In short, sunspots matter. And they matter in a big way.


We show that financial markets cannot work well in the real world except by chance because:

  • There are many equilibria;
  • Only one of them is Pareto efficient;
  • For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way that they would prefer to avoid, if given the choice.

Our paper makes some classical assumptions, but has Keynesian policy implications. Agents are rational, they have rational expectations and there are no financial frictions. Even when agents are rational, markets are not.


Azariadis, Costas (1981), “Self-fulfilling Prophecies”, Journal of Economic Theory, 25, 380-396.

Cass, David and Karl Shell, “Do Sunspots Matter?” (1983), Journal of Political Economy, 91(2), 193-227.

Davis, Steven and Till Von Wachter (2011), “Recessions and the Costs of Job-Losses”, Brookings Papers on Economic Activity.

Farmer, Roger E A (2012a), “The Evolution of Endogenous Business Cycles”, NBER Working Paper 18284 and CEPR Discussion Paper 9080.

Farmer, Roger E A (2012b), “Qualitative Easing: How it Works and Why it Matters”, NBER working paper 18421 and CEPR discussion paper 9153.

Farmer, Roger E A, Carine Nourry and Alain Venditti (2012), “The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World”, CEPR Discussion Paper No. 9283.

Fox, Justin (2009), The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street, New York, Harper.

Thaler, Richard (2009), “Markets can be wrong and the price is not always right”, Financial Times, 4 August.

1 See my survey (Farmer 2012a), which documents the evolution of the Pennsylvania School of Endogenous Business Cycles.

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