[Editor's Note: L. Albert Hahn was a German banker and investor who made his name in the mid-20th century as a critic of Keynesian economics. Grounded on an Austrian understanding of the business cycle and uncertainty, Hahn depicts the stock market as being overwhelmingly inhabited by investors whose thinking is constrained by mass opinion. In this selection from the Quarterly Journal of Austrian Economics, George Bragues examines Hahn's views of stock markets and what this might tell us about today's Efficient Markets Hypothesis (EMH).]

Until recently, the Efficient Markets Hypothesis (EMH) demonstrated an impressive resiliency in the face of discordant events. It emerged from the 1987 stock market crash only slightly bruised, though the Dow Jones Industrial Average fell a record 22.6 percent in a single day when the only news that might have possibly accounted for such a cataclysm was a disagreement among industrialized nations about currency and interest rate levels. Somehow, though it was left tottering, it managed to survive the denouement of the late-1990’s dot-com bubble. During this bubble, the NASDAQ Composite Index nearly quadrupled in an eighteen month period. Internet companies, such as eToys and TheGlobe.com, were accorded multi-billion valuations despite generating limited revenues and no profits. With the financial crisis of 2007–2009, however, it seems that the EMH has finally succumbed. Here was a situation, after all, in which a multitude of sophisticated analysts and investors, operating in the world’s leading financial institutions, grossly overvalued the mortgage backed securities at the heart of the crisis and systematically undervalued the risk in their portfolios, all the while relying on models quantitatively constructed on the assumptions of the EMH (Dowd and Hutchison, 2010).

Just as the crisis has revived Keynesian ideas in macroeconomics, so it has led observers to revisit the sections of The General Theory of Employment, Interest, and Money that address the behavior of securities markets. There, Keynes (1964) compares the stock market to a giant casino, describing investors as fundamentally driven by “animal spirits,” making decisions to buy and sell based on the estimated direction of crowd psychology as opposed to the intrinsic value of financial assets. Today, this Keynesian perspective is being taken up by Behavioral Finance (BF), a school of thought that began percolating at the margins of financial economics in the mid-1980’s and which has since dethroned the EMH of its monopoly status in the discipline to become a formidable alternative. Based on the work of Amos Tversky and Daniel Kahneman (1979, 1982), BF applies the findings of psychology to explain price formation on securities markets. Opposing the EMH presupposition of human beings as utility maximizing calculators, BF sees the mind as inextricably swayed by emotions, feelings, social influences, cognitive biases, and heuristics (Baker and Nofsinger, 2010; Ackert and Deaves, 2010; Schleifer, 2004).

No doubt, BF offers a useful corrective to the EMH. Yet common sense, in tandem with a bit of elementary logic, suggests that it cannot fully account for market phenomena. If everyday observation amply confirms that we are not cool logicians, it also reveals examples in which people manage to overcome their biases and control their passions. An investor is often enticed by greed to buy a penny stock touted on an Internet newsgroup only to be brought back to reason by the realization that the deal is too good to be true. What is more, markets surely do regain their senses after bouts of extreme pessimism and optimism. And while prices may not always be exactly right, it would be hard to deny that, on occasion at least, certain securities, if not stocks in general, are correctly valued. Yet if the human mind is the servant of sub-rational forces, as BF seems to claim, these moments of rationality are a puzzle. If it is such a challenge to impartially reason, how then do we manage to get things right from time to time?

This suggests we ought to explore the possibility of a middle way between the EMH and BF. In search of this, we return to the writings of Lucien Albert (L.A.) Hahn, a self-styled common-sense economist who first gained notice with his Economic Theory of Bank Credit (1921). In a career that traversed the worlds of academia and banking, Hahn attained his greatest level of fame with The Economics of Illusion (1949), a critique of Keynes, before laying out his own economic theory in Common Sense Economics (1956). Since then, Hahn’s work has been almost forgotten; only two articles on Hahn come to sight in the scholarly literature over the last twenty years (Selgin and Boudreaux, 1990; Leeson, 1997).

Hahn’s views on the stock market are set forth in the final part of Common Sense Economics. Embarking from an Austrian understanding of the business cycle and uncertainty, fleshed out with insights from psychology, Hahn argues that stock prices result from a combination of objective and subjective factors. On his account, the influence of mass opinion and mental inertia over most people’s psyches generates sustained divergences from intrinsic values. Sooner or later, Hahn observes, these distortions are corrected by the pull of the objective facts in a process led by a few alert, independently minded investors. In Hahn’s analysis — which this paper finds has stood the test of time — financial markets are neither perfectly efficient, nor animally spirited, but eventually adjusting.

Read the full article at the QJAE.