Efficient Market is One of Many Nash Equilibria

The Economist magazine recently published an article (see here) expostulating on how the financial crisis cast doubts on one of the most important tenets of financial economics: the Efficient Market Hypothesis (EMH). In its strongest form, the EMH states that all relevant information about an asset is reflected in its market price. This is the foundation on which financial institutions built their complex derivative products, the mis-pricing of which culminated in the financial crisis. The article delineates the world of theoretical economics to be in disarray: researchers disagree vehemently whether to retain the old foundations of financial economics, or to adopt new theories based on Behavioral economics or some “adaptive markets hypothesis" based on evolutionary theory.

I think that the confusion is exaggerated, and the explanation why supposedly "efficient" markets can be so distorted is simple. Instead of questioning basic economic tenets such as rationality, I propose that we view markets in light of simple Game Theory: markets will converge toward a Nash Equilibrium, and an efficient market in which prices reflect all information is only one or many possible Nash Equilibrium.

The basic logic behind the Efficient Market Hypothesis is clear and simple: if there is a way to make above average returns in the stock market, then savvy investors can perform the corresponding trades and make money; hence, such opportunities cannot remain for long. But oftentimes people extend this too far, and argue that this mechanism causes the market price to be always "correct," because it is too low or too high, investors can buy or sell and make money. (This also happens to be the argument for EMH in the Economist article), The fallacy in this argument is that for investors to make money, market price [has to return to its "correct" value] in a reasonable amount of time, so that the savvy investors can lock into their profits. In other words, this assumes that other participants of the market will also act to correct the market price; it assumes an "efficient market" Nash-equilibrium.

However, a wildly ballooning market bubble can also be a Nash equilibrium, because if others are blindly buying shares to raise the market price, it may be one's best strategy to join the bubble and benefit, as long as one expects the bubble to continue in the foreseeable future. Moreover, it may be disastrous to try to correct the market, because betting against the market for an extended period of time may require an astronomical budget, and no profit can be made in the near future. Hence, the supposed "irrational" behavior of participating in a market bubble can be entirely rational, especially if budget constraints or time-discount-factors are present.

Perhaps the new paradigm of financial economics that emerges from this crisis should be built on Game Theory?