There are, as blogees know well, two dominant schools in capital market theory: those who believe in the rationality and efficiency of markets, and those, drawing on the wellspring of behavioural research, who see markets as reflectors of flawed human reasoning. Like most polarised debates the resolution lies at a deeper level. Many years ago when writing about the Roll critique of capital asset pricing, I gained some notoriety and later acceptance for the position that this was at heart a dispute between scholars who took a Realist and those who took an Instrumental view of the status of theories. Again with the the EMH/Behavioural argument I think there are two sides who have not explored and agreed on their fundamental understanding of how complex social phenomena - like markets - work.
Behavioural explanations of market behaviour work from the reductionist principles of Aristotle and William of Ockham. Ockham was a 12 Century cleric who summarised the Aristotelian argument that knowledge of complex things can be reduced to knowledge of simpler things. Ockham’s Razor is much cited in scientific circles: ‘entities should not be multiplied beyond their necessity’ or, to put it more simply: always look for the simplest explanation. If you see a scatter of dots on a graph assume that they are related by a straight line rather than a wave form. However, reductionism has a broader agenda. Markets are complex phenomenon so explain them through simpler theories of human agency, motivation and behaviour. But human behaviour is a complex phenomenon so attempt to explain that in terms of human emotion, cognitive states, and limits on human cognition etc. But these too are complex phenomenon so attempt to explain them through brain state research, neuroscience and ultimately brain chemistry. This reductionist agenda is compelling and, in the natural sciences, has been extraordinarily successful in gaining understanding of the natural world. But does it miss something out?
There is in complex systems another type of phenomenon which the reductionist agenda assumes away, or if it cannot assume it away attempts to resolve by reductionism often with a spectacular lack of success. There is no doubt that human mental states are hugely complex and a product of billions of neurons firing within the brain passing tiny electrical impulses from one place to another. But none of this analysis of objective physical processes can explain successfully the subjective quality of brain activity we describe as consciousness. Consciousness is an emergent phenomenon which arises when a functioning brain, doing what functioning brains do, creates a mental state which is different in order and in kind from that which is below it. Emergent phenomena of this kind have proved extremely resistant to the reductionist agenda. Complex systems invariably produce patterns and behaviours which cannot be readily deduced from the behaviour of their component parts. Market rationality and efficiency is, I would argue, an emergent phenomenon of this type. We can discern certain motivating influences which might, in part, explain the efficiency phenomenon: the law of large numbers, opportunism, legal structures and regulation and so on.
However, like all emergent phenomena it can break down but in my view we can only understand how it works and how it fails by understanding the drivers of emergence and how they come together to create something which is much bigger and better than the sum of its parts.