Richard Thaler, the researcher whose work has brought such key behavioral finance issues as myopic loss aversion to light, says recent events have shown markets are not efficient, but that they are still the best way to employ capital.
“Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory,” Thaler wrote in The Financial Times. “They led to misallocations of resources measured in the trillions and … the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be ‘right’, then these bubbles would not occur. … [But] while imperfect, financial markets are still the best way to allocate capital.”
Thaler says that because prices are inefficient, governments could take steps to help stabilize markets. Among them: linking the down-payment for mortgages to a measure of real estate “frothiness”, and ensuring that bank reserve requirements “are set dynamically according to market conditions”.
Thaler also offers a good summary of the history of efficient market hypothesis and its impact on modern financial theory. And he makes some interesting observations about the nature of bubbles, and trying to predict them. For example, even knowing that a bubble is happening doesn’t mean you can profit from it, he says: “Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble.”