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How Did Financial-Crisis-Based Criticisms of Market Efficiency Get It So Wrong?

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  • Ariane Szafarz

Abstract

Criticizing the Efficient Market Hypothesis (EMH) on the basis of highly volatile asset prices is conceptually wrong as efficiency is about rationality and information, not about stability. Speculative bubbles are compatible with rational valuation, and hence with market efficiency. As rational expectations are auto-referential, multiple solutions are a natural outcome. This paper attributes the prevalent confusion between bubbles and irrationality to the bad reputation of multiple-solution models often considered as underspecified. It argues that multiple solutions rather represent an opportunity to economists by bringing theoretically sound degrees of freedom to empirical implementation. Moreover, the recognition of multiple price dynamics compatible with market efficiency thwarts irrationality-based theories and, as such, is a valuable asset largely underestimated by the profession.

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Paper provided by ULB -- Universite Libre de Bruxelles in its series DULBEA Working Papers with number 10-01.RS..

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Date of creation: 2010
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Handle: RePEc:dul:wpaper:10-01rs

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Keywords: Efficient Markets; Multiple Solutions; Rational Expectations; Speculative Bubbles; Volatility.;

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References

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Cited by:
  1. Costa Cabral, Nazare, 2010. "Breve guia temático e bibliográfico sobre o estudo da actual crise financeira e económica
    [Short thematic guide to the study of current financial and economic crisis]
    ," MPRA Paper 20743, University Library of Munich, Germany.

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