IDEOLOGY AND THE THEORY OF FINANCIAL

ECONOMICS
by

George M. Frankfurter*

and

Elton G. McGoun**

Do Not Quote Without the Permission of the Authors

*Department of Finance, E.J. Ourso College of Business Administration, Louisiana State
University, Baton Rouge, LA, 70803-6308, 504/388-6369, Fax 504/388-6366,
FIFRAN@LSUVM.SNCC.LSU.EDU
**Department of Management, Bucknell University, Lewisburg, PA 17837, 717/524-3732 Fax 717/524-

1338, MCGOUN@BUCKNELL.EDU

Minor style editing in September 2018

The paradigms of modern finance are the result of a type of academic thinking inspired by a
positivist philosophy. Philosophers of science argue that this positivism of Milton Friedman is
"value neutral"; that is, it is not influenced by any particular political view of the world. In
this paper, using the ubiquitous Efficient Markets Hypotheses as an example, we argue that both
the ontology and the epistemology of financial economics are decidedly value impregnated, however
well the methodology masquerades as perfectly objective. It is important that scientists
(researchers) recognize the ubiquity of ideology in finance and admit and understand the values
implicit in its neoclassical methodology. With different beliefs and their attendant
methodologies, the concept of "market efficiency" would be entirely different, if it at all
existed.

Acknowledgments

The authors wish to thank two anonymous referees for their kind remarks,
encouragement and suggestions. We are also indebted to the editor of this
journal whose critical comments, constructive suggestions and patience proved
to be invaluable. Appreciation is also expressed to Professors Ya’akov
Bergman and Myron Gordon who commented on an earlier draft of this paper.
All usual disclaimers of responsibility to others but us, apply,
nevertheless.

JEL Classification Code: G14

KEYWORDS: Financial Economics, Ideology, Methodology, Market

Efficiency.
 IDEOLOGY AND THE THEORY OF FINANCIAL
ECONOMICS
INTRODUCTION

What, then, is truth? A mobile army of metaphors,

metonyms and anthropomorphisms--in short, a sum of
human relations, which have been enhanced,
transposed, and embellished poetically and
rhetorically, and which after long use seem firm,
canonical, and obligatory to a people: truths are
illusions about which one has forgotten that this is
what they are; metaphors which are worn out and
without sensuous power; coins which have lost their
pictures and now matter only as metal, no longer as
coins.--Nietzsche

Indeed, as the documents of science pile up, are we

not coming to see that whole works of scientific
research, even entire schools, are hardly more than
the patient repetition, in all its ramifications, of
a fertile metaphor?--Burke

The paradigms of financial economics (what is sometimes

also called modern finance) are the result of a type of academic

thinking inspired by a positivist philosophy. This philosophy

has been based on Milton Friedman’s (1953) now-famous essay,

“The Methodology of Positive Economics,” and later modified by

other well known researchers, including Robert Lucas and Eugene

Fama, to fit their narrowly defined purpose. The most

significant financial economics paradigms are also imbued with

the fundamental canons of neoclassical economics and the belief

that the firm exists for no reason other than the economic
pleasure of the shareholder. These paradigms include the

efficient markets hypotheses1 [EMH, subsequently], the capital

asset pricing model [CAPM, subsequently], and the Modigliani and

Miller irrelevance theorems (Modigliani and Miller, 1958; and

Miller and Modigliani, 1961).

Philosophers of science argue that the logical positivism

of Friedman is “value neutral”; that is, it is not influenced by

an ideological view of the world. Although there is no denying

that the notion of an omnipotent market (de facto, the ideology

of laissez faire, or radical individualism) is the corner-stone

of all the theories of financial economics and furthermore that

the idea of shareholders’ value maximization2 is the top of the

hierarchy of the goals of the agent/manager, neither are

necessary in a purely positivist methodology.

In this paper, we argue that both the ontology (what there

is to know) and the epistemology (how it is to be known) of

financial economics are value impregnated. In section I we show

that what we believe ought to be there leads to what we think is

there. And what we believe is there leads to how we can prove

that it is, indeed, there, whether it is there or not.

In sections II and III, we use the EMH as an exemplar3 to

discuss the philosophical connections between ideology and

ontology, and ideology and epistemology. In the concluding

section we propose an explanation for the prevailing ideological

hegemony and point to its inherent exigencies.

I. IDEOLOGY: BELIEFS AND LANGUAGE

“When I use a word,” Humpty Dumpty said in rather a

scornful tone, “it means just what I choose it to mean--
neither more nor less.”
“The question is,” said Alice, “whether you can make words
mean so many different things.”
“The question is,” said Humpty Dumpty, “which is to be
master--that’s all.”--Lewis Carroll, Through the Looking
Glass, quoted in Friedman (1954).

One must exercise extreme caution when using the word

ideology, for it packs quite an emotional punch. In Iconology:

Image, Text, Ideology. Mitchell (1986) distinguishes between

two senses of "ideology":

The orthodox view is that ideology is false consciousness, a

system of symbolic representation that reflects an historical
situation of domination by a particular class, and which serves
to conceal the historical character and class bias of that system
under guises of naturalness and universality. The other meaning
of 'ideology' tends to identify it simply with the structure of
values and interests that informs any representation of reality;
this meaning leaves untouched the question of whether the
representation is false or oppressive. In this formulation,
there would be no such thing as a position outside ideology.

Consistent with the second meaning, ideological does not

have to mean political. More important, it does not have to

have a negative connotation. This is not the case about the

first meaning. As much as one is inclined to embrace the second

meaning (as logically possible), it must be emphasized that

every methodology is ideology saturated; therefore, no

methodology can be value neutral. Acknowledging this fact does

not make one a wild-eyed Marxist/national socialist-

fascist/totalitarian/anarchist, who throws rocks at laissez-

faire. It is vital that scientists (researchers) recognize the

ubiquity of ideology and admit and understand the values

implicit in a neoclassical methodology.

Accordingly, one must acknowledge that it is fiction to

assert that any methodology can be "value neutral."

Nonetheless, the methodology underlying today’s financial

economics is often claimed to be the one true approach to

knowledge because of its objective appearance and its ability to

masquerade as “value neutral.” It is ideological in the sense

that it is imbued with certain beliefs and cast in a certain

language that make it out to be what its believers want it to be

and not the way things in any sense "are."

Beliefs

Neoclassical economists are often accused of playing an

underhanded game.4 They take a non-tautological version of

rationality, and then defend the concept by using a tautological

version. That is, they take a term in general and give it a

technical definition. Efficiency,5 with its constructive and

positive connotations, is a good example. Practically speaking,

it means Pareto optimality, but the term masks a moral issue

that is completely suppressed. How can existence side by side,

of “have’s” and “have-nots” be termed “efficient” in a moral

sense? How can deci-millions who have no medical insurance

exist side by side in a society with those who can, at the age

of 90 or older, be kept indefinitely on life-support equipment?

In dealing with the allocation of budgets or wealth,

neoclassical economics assumes that the individual has a free

choice and that the person is a homo economicus utility

maximizer. This is the context in which Pareto efficiency makes

sense. This notion is, of course, value laden. Many people

whom economists, for some reason, like to call “agents” either

have no free choice, or must select the lesser of two

undesirable alternatives.

The latter predicament--in which the individual selects the

lesser of two undesirable outcomes--can be called pessimality.

A striking6 and well-known example is the judgment of King

Solomon concerning a baby claimed by two women (1 Kings 3:14-

24). The natural mother of the child must choose between seeing

her baby cut in half or giving him up. She accepts the second

alternative, but, if her choice had been optimal, she would not

have been before the king in the first place. In the biblical

account her predicament is solved and the situation ends

happily. Not all real pessimalities are resolved this way. To

illustrate the point some cite Sophie’s Choice in which the

protagonist had to choose the life of one of her two children.

Pessimality as a concept cannot exist under the ideology of

individualism, which is the underlying philosophy of Adam Smith.

Smith was a radical individualist whose beliefs impregnated his

economic thinking, creating a utility-based version of radical

individualism. Radical individualism was a reaction to a

repressive authoritarian rule (of king and church), replacing

such rule with the invisible hand of a higher order: the

omnipotent market (see: Reiter, 1996; and Etzioni, 1988).

Smith envisaged a one-for-all, all-for-one bucolic

relationship between a single entrepreneur and an assembly of

craftsmen who worked for the entrepreneur. In this kind of

social order, the laissez faire of the market replaces the

authoritarian rule of the monarch. The idea of eliminating, or

at least weakening, as much as possible a central government’s

power is a perfect ideological fit with the political views of

today’s free-market economists.7

These economists have severe difficulties, however, in

resolving the paradox created by the existence of the corporate,

often multi-national, giant. In this milieu, there is no

bucolic relationship between an assembly of craftsmen and a

single entrepreneur. Such a relationship is impossible in an

era of downsizing, when top executives are handed golden

parachutes, and astronomically vast compensation chasms separate

between managers and assembly-line workers. The ideology of

getting “big government” out of the picture, is convenient for

those who tout the idea of the omnipotent market as long as they

can control it as much as possible.

Neoclassical economics is the ideological foundation of

positive economics. As Reiter observes:

Positive economics theories are, therefore, politically

situated and motivated. Strassman (1993) points out that the
economic theoreticians get away with such partisan activities by
presenting their theories as objective and hiding the “role of
personal, social, and political values” (p. 160). And yet, the
strong, if unidentified, political-ideology attractiveness of
financial economics theory may explain at least part of its
attractiveness to business and to research (ibid.).

Language

As they embody our beliefs, words are not neutral. They

have both connotative and denotative meanings that are value

laden. To use an existing word to describe a new phenomenon

means attaching to the phenomenon all the meanings and images

associated with that word--not only those that seem to apply

(which were those that caused the word to be chosen in the first

place), but also those that may not. This sort of attachment

affects our perception of the phenomenon. Why else would we

want a particular word to describe a new phenomenon rather than

another equally appropriate word? We choose one word over

another because our values predispose us to prefer its meanings

and images. In this way, we attach our values to the phenomenon

and change (or perhaps strengthen) our perception in a desired

direction. In short, we use language to make the world out to

be what we want it to be. This is undoubtedly true of the idea

which eventually came to be known as “market efficiency.”

Fair Games

The earliest work on the mathematics of what we now call

market efficiency is usually considered to be Bachelier’s

dissertation, completed in 1900 (Cootner, 1964; Fama, 1970).

The dissertation, translated into English by A. James Boness,

was published in 1964 (Bachelier, 1964). In this work,

Bachelier restricts himself to the language of probability.8

Even this supposedly purely technical language, however, is

value-impregnated, as certain terms in the language reflect the

origins of the probability calculus in studies of gaming. For

example, Bachelier explains, “Obviously a player will have

neither advantage nor disadvantage if his total mathematical

expectation is zero. Then the game is called a ‘fair game’”

(ibid., p. 26). If “the mathematical expectation of the

speculator is zero” (ibid., p. 28), as Bachelier later asserts,

then we must conclude that market speculation is a “fair game.”

In using the language of probability, we not only create a

metaphor of markets as “games of chance,” but also assert that,

as games of chance, markets are “fair.” Although Bachelier

certainly did not originate this metaphor, his work reinforces

it.9 “Fair game” is much more than a value-neutral technical

term in the language of probability. Once the term has been

applied to markets, we cannot avoid mentally associating the

markets with games of chance, nor can we avoid the judgment of

“fairness.” This association and judgment occur whether or not

we would agree that markets are “games” or “fair” or either if

called upon to express an opinion on the matter.

Although we are not privy to Bachelier’s thoughts when he

chose to apply the term “fair game” to markets, we can suppose

that he selected the term because it reflected his beliefs

regarding markets. The term, in turn, reinforced his beliefs.

In other words, if he had not already thought that markets were

a “fair game,” he would not have applied the term, nor would he

have used the associated mathematics as well. At that time, the

notion that markets were “fair games” was not uncommon.

Anybody who can guess right six times out of ten can carry off
all the stakes in any gambling game that is long continued. If
Wall Street could do this, Wall Street would long ago have
absorbed all the floating capital in the country and have retired
from business for want of more pablum (White, 1909, p. 533).

Another matter worth considering is Bachelier’s timing.

Why did this application of the mathematics and language of

probability occur in 1900, rather than earlier or later?10 We

cannot answer this question with certainty, but we can note that

the end of the 19th century was a time of significant advances

in inferential statistics (Porter, 1986). There was an interest,

therefore, in probabilistic and statistical methods. Young

researchers like Bachelier would have been expected to seek

applications for the latest techniques. Harry Markowitz’

application for mathematical programming, for example, led to

his Nobel prize-winning work in portfolio selection (Bernstein,

1993).

The notion of the market as a “fair game” persisted among

practitioners for many years, albeit with a subtle difference.

Their metaphor for the market was a “fair game” not of chance,

but skill. That is, with sufficient intelligence, diligence,

and patience in using fundamental or technical analysis, a

person of humble origins could become a respected investor. To

someone whose wealth was attributable to the market, this would

have been a comforting myth. The alternative was to admit that

one was a mere speculator, whose success was a consequence of,

at best, chance or, at worst, manipulation. Recall that the

speculator was the evil bête noire whose nefarious machinations

were thought to have caused the crash of 1929.

Academics were torn between these two metaphors. On the

one hand, no one was able to produce convincing evidence that

any economic phenomenon could be reliably forecast using

historical economic data; in effect, the economy was a “fair

game” of chance. On the other hand, there had to be some other

way to understand economic phenomena; in effect, the economy

ought to be a “fair game” of skill. This problem is implicit in

the following quotation from a review of Oskar Morgenstern’s

1928 Wirtschaftsprognose: Eine Untersuchung ihrer

Voraussetzungen und Möglichkeiten:

The whole drift of a great part of Dr. Morgenstern’s detailed

argument. . . centers around the proposition that economic
statistics, from their very nature, provide an incomplete
understanding of economic processes; that ‘purely statistical’
considerations can never satisfy as a means of explanation and so
ultimately of forecast. This has been argued by other,
intelligent statisticians no less than by theorists (Marget,
1929, p. 319).

Concerning the stock market, a speaker at a dinner meeting

of the American Statistical Association on April 17, 1925, noted

that the market looked as if it were indeed a “fair game” of

chance, but he fell short of declaring that it was:

He [Frederick R. Macaulay of the National Bureau of Economic

Research] observed that there was a striking similarity between
the fluctuations of the stock market and those of a chance curve
which may be obtained by throwing dice. If the stock market can
be forecast from a graph of its movements, it must be because of
its difference from the chance curve (Forecasting Security
Prices, 1925, p. 248).

The only basis for resolving the conflict between the two

metaphors was ideological. There was no scientific basis for

the belief that economic phenomena could be understood or

explained or forecast, but one could not practice economics

without believing that they could. If there were not something

to know about economics (including the stock market), then it

was not only futile, but also foolish, to attempt to find it.

If the market were a “fair game” of chance, then there would be

as little skill in knowing it as there would be merit in playing

it. But if the market were a “fair game” of skill, then the

stature of its scholars was as well deserved and as indicative

of superior qualities as the wealth of its investors.

It is a common practice that scientists do not attempt to

follow the Popperian prescription of falsification; instead,

they try confirmation of theories to which they have become very

firmly attached. How much more tenaciously would one adhere to

a belief if it were professional existence that were at stake

and not just professional reputation? Thus, from the beginning,

we believed that something was there; that is, that there was

some way to understand or explain the stock market. But this

ideology had a disturbing inconsistency. How could we

understand or explain the stock market without being able to

forecast it?

Random Walk

This inconsistency must have bothered Alfred Cowles, eponym

of the Cowles Commission for Research in Economics at the

University of Chicago:
 It seemed a plausible assumption that if we could demonstrate the
existence in individuals or organizations of the ability of
foretell the elusive fluctuations, either of particular stocks,
or of stocks in general, this might lead to the identification of
economic theories or statistical practices whose soundness had
been established by successful prediction (Cowles, 1933, p. 309).

And although it is not a necessary logical implication, the

absence of “the ability to foretell the elusive fluctuations”

does not bode well for the “identification of [sound] economic

theories or statistical practices.”

That the Cowles Commission was housed at the University of

Chicago may have something to do with subsequent developments

there. However, as an interesting historical tidbit, there was

not too much love lost between the commission and Friedman.

Part of Friedman’s (1953) essay is dedicated to “getting even”

with the Cowles Commission. We want to make it clear that there

never was any ideological link between Friedman and Cowles.

In a series of papers (Cowles, Cowles and Jones, 1937, and

Cowles, 1943), Cowles tested a number of market forecasting

techniques, none of which performed better than pure chance.

However, there was no theoretical follow-up to these empirical

findings, and the topic fell into obscurity until the 1950s.

Perhaps the ideology is still to blame. Under the hypothetical-

deductive model of explanation that was current at the time

(Nagel, 1961; Hempel, 196511), explanation implied prediction and

vice versa. Without prediction, there was no explanation, and

if there were no explanation, it did not make professional sense

for an economist to look for one. So it was better to ignore

the matter entirely. And for practitioners, it made even less

sense to acknowledge that their techniques were ineffective.

In an article published in 1953, Kendall (1964) explicitly

states that unpredictable price movements are likely to be

unpalatable to economists.

It may be that the motion is genuinely random and that what looks
like a purposive movement over a long period is merely a kind of
economic Brownian motion. But economists--and I cannot help
sympathizing with them--will doubtless resist any such conclusion
very strongly (ibid, p. 92).

Kendall also states that the price movements will be equally

unpalatable to investors:

But it is unlikely that anything I say or demonstrate will

destroy the illusion that the outside investor can make money by
playing the markets, so let us leave him to his own devices
(ibid., p. 94).

Although he claims to be sympathetic with the economists,

Kendall was a statistician who had no professional stake in

sustaining the ideology that the market could be explained.

Kendall was not the first, however, in the frequently cited

literature to have the temerity to suggest that price movements

were “genuinely random.” In 1934, another noted statistician,

Holbrook Working, observed:

It has several times been noted that time series commonly possess
in many respects the characteristics of series of cumulated
random numbers. The separate items in such time series are by no
means random in character, but the changes between successive
 items tend to be largely random (Working, 1934, p. 11).

The economist Cowles (1943) compared the record of stock market

forecasters with a “random forecasting record,” but never went

so far as to assert that price movements themselves were random.

Note that both Working and Kendall hedged a bit. Neither

was willing to say that price series were “random,” although we

cannot know whether this was because of ideology or professional

caution. The dread word random has an interesting etymology.

According to The Oxford English Dictionary (1989), it first

appeared in 1305 with the meaning “impetuosity, great speed,

force, or violence.” Later, in the sixteenth century, it

acquired the additional denotations of “without consideration,

care or control” and “at haphazard, without aim, purpose, or

fixed principle; heedlessly, carelessly.” This is a word an

economist would be reluctant to apply to an economic phenomenon.

It was not until 1898 that random first appeared in a

statistical sense (in The Philosophical Transactions of the

Royal Society). It is not surprising, therefore, that Bachelier

does not use the word in his 1900 article. There was plenty of

time, however, for it to be applied to price movements before

1934. (Recall how close Frederick Macaulay came in 1925.) But

the key term in the economic literature is “random walk,” which

first appeared in statistics in 1905 (in Nature), but did not

appear in economics until 1959, when it was used by yet another

statistician, Osborne (1964), in “Brownian Motion in the Stock

Market.” (It was two years later, in 1961, that “random walk”

first appeared in the title of an article--“Price Movements in

Speculative Markets: Trends or Random Walks” Alexander, 1964).

It was also in 1959 that the idea of chance returned to

economics in general (and to the finance literature in

particular), this time to stay, by way of Harry Roberts, a

University of Chicago statistician (1964). Roberts’ terminology

was very cautious. He used only the term “chance model” and

avoided the word random altogether, except in a quotation from

Working and about a random number table. He acknowledged that

there is an ideological reaction to “chance” (let alone to

“random”), and softened his conclusions:

In another sense the reaction against “chance” is sound. Much

more empirical work is needed, and it seems likely that
departures from simple chance models will be found (Roberts,
1964, p. 13).

Roberts’ major contribution was to suggest a theoretically

(and more importantly, intuitively) plausible reason why

prediction of the stock market was impossible:

If the stock market behaved like a mechanically imperfect

roulette wheel, people would notice the imperfections and by
acting on them, remove them. This rationale is appealing, if for
no other reason than its value as a counterweight to the popular
view of stock market “irrationality” (Roberts, p. 13).

Thanks to Roberts, economists could now believe in an

unpredictable stock market without compromising their

professional existence as scientists, and thanks to Osborne,

they had a new term, “random walk,” to label the new ideology.

Of course, “random walk” is a technical term just as “fair game”

is, but we have shown that “fair game” is also a value-laden

term, and so is “random walk.” As we have discussed, a “fair

game” metaphor for the market can be reinterpreted as a “fair

game” requiring skill. There is no similar way to hedge the

metaphor of a “random walk.” The market falters blindly along

at random, and all we can do is follow it. This is a very

disturbing metaphor, not only for practitioners, for whom it

admits no role in investment selection whatsoever, but also for

everyone who believes in the efficacy of markets. Who would

want to think that institutions, social as well as economic, are

random? Although academics could now permit themselves to study

market price movements, it sounded as if it were a rather

nihilistic pursuit.
II. EFFICIENCY--THE IDEOLOGY-ONTOLOGY CONNECTION

Philosophical concepts--the very touchstone of

intellectual rigour and truth--are often found in
buried and forgotten metaphors.
Metaphoricity is the logic of contamination and the
contamination of logic.--Norris

The first use of the word efficient do describe a portfolio

selected by an investor is by Markowitz (1952). His definition

is purely technical. He defined an “efficient portfolio” as

collections of assets for which Max p|²p  Min ²p|p, subject to

first order  = ²p, and boundary conditions, for individuals

with quadratic utility of wealth. This definition is the well-

known mean-variance efficiency criteria. It is not for us to

guess why Markowitz called these collections of assets the

“frontier of efficiency,” rather than the “quadratic man’s

choice,” or any of a score of other names. Perhaps he chose

efficient because the word has positive connotation, being the

opposite of “wasteful.”

In any case, Markowitz never intended for the word to be

used in connection with a market. His model was for an

individual investor, and was not intended as a mechanism to

explain the operation of the markets. The use of the word in

the context of markets is mainly attributed to Fama: “A market

in which prices always ‘fully reflect’ available information is

called ‘efficient’” (Fama, 1970, p. 383).

 “Efficient market” is perhaps one of the most momentous

terms in modern financial economics. The term appeared five

years earlier, buried in another article by Fama (1965), but it

had no impact then on the profession.12

. . . a situation where successive price changes are independent

is consistent with the existence of an ‘efficient’ market for
securities, that is, a market where, given the available
information, actual prices at every point in time represent very
good estimates of intrinsic values (Fama, 1965, p. 90).

The first part of the 1965 definition is an apparent

reference to random walk, “. . . where successive price changes

are independent. . . .” This definition makes Brownian motion a

prerequisite of market efficiency. Also, note the significant

difference between the 1965 and 1970 definitions. In the 1965

definition, prices in an efficient market not only incorporate

“available information,” but also are “very good estimates of

intrinsic value.” This is quite a bold claim. In the 1970

definition, however, prices in an efficient market have only to

“fully reflect available information.” Whereas the earlier

definition might be considered “efficiency” in the

scientific/economic sense of the term with which most of us are

familiar [“The ratio of useful work performed (intrinsic price

discovery) to the total energy expended or heat taken in

(information)” (OED, 1989)], the later definition harks to an

earlier (and largely obsolete in common use) philosophical

definition: “The fact of being an operative agent” (ibid.).

In Western culture, and especially in Protestant ethics,

“efficiency” is a morally good thing--certainly an attribute

that we want our social and economic institutions to have. It

is no wonder that this term, however technically inaccurate and

inapplicable, was seized upon by academics to describe their

work on market prices. What pursuit could be more admirable

than investigating the “efficiency” of markets? And in a

broader ideological sense, who would dare to tinker with the

prices of “efficient” (ethically laudatory) markets. Although

policy makers would certainly be justified in managing

(regulating) markets governed by a “random walk” to achieve less

random, more socially desirable ends, “efficient” markets are

already working efficiently, and managing (interfering with)

them can only make them inefficient.

Of course, neither those markets governed by a “random

walk” nor those described as “efficient” left much room for

practitioners to maneuver, so they fought back. But, since it

was much easier to attack a “random walk” than to attack

“efficiency,” the former term lasted much longer in the

practitioner literature than in the academic literature.

Although technical market efficiency is under increasing attack

today, the term “market efficiency” remains in nearly universal

use. Until an entrepreneurial academic coins a catchy

successor, our markets will continue to have the image of

efficiency, whether they in fact are.

In a sense, we have come full circle, ideologically and

metaphorically, with the term “efficiency.” Although we have

negated the image of “game,” (which is incompatible with

practitioner professionalism, academic scholarly respectability

and religious beliefs), we have enhanced the image of “fair.”

Now, markets are not only value free (“fair”), but also

exceedingly good at doing whatever it is they do at the least

social cost (“efficient”). They are the same markets, but they

look a lot better after the terminology make-over.

III. THE EMH–THE IDEOLOGY-EPISTEMOLOGY CONNECTION

Touchstone: Of a certain knight that swore by his honour

they were good pancakes, and swore by his
honour the mustard was naught; now, I’ll stand
to it, the pancakes were naught and the mustard
was good: and yet was not the knight forsworn.-
-Shakespeare, As You Like It, Act I, Scene II.

Ideology--Epistemology

The purpose of this section is not to survey the EMH

literature, but rather to show the connection between the

ideology currently espoused by financial economics and its

epistemology.13 We will demonstrate, first, that the proposition

of market efficiency as an hypothesis, and the ensuing tests

thereof, could have evolved only under an ideology that

attributes both desirable properties and omnipotence to

“markets,” and, second, we will argue that the methods of

analysis used to show the validity of this proposition

effectively immunized the hypothesis against the possibility of

rejection.14

A recently published paper deals with the EMH, more as a

philosophy and or as the basis for a “research program”15 than as

a survey of empiricism. This paper by Ball (1996), representing

the Chicago School, was not published in the nobility press,

because an article with philosophical undertones is rarely, if

ever, published in the so-called "most prestigious" journals.

Ball (1996) gives the impression that one has to stick with

the EMH because (1) we don’t have anything better, (2) it

sufficed in the past, and (3) it is now a matter of belief.

Indeed, alternatives to the EMH are few. Ball can think of only

one, which he calls “‘behavioral’ finance,” (ibid., p. 10)

referring, principally, to the works of DeBondt and Thaler

(1982, 1985). Ball (ibid., pp. 10-11) dismisses this

“behavioral finance” because:

 Investors’ myopia implied by the DeBondt and Thaler

work would be “grossly inconsistent” with the notion
of competitive markets. (How could one possibly doubt
that they are competitive?)

 Behavioral finance is also replete with its anomalies.

(Let he who is without sin cast the first stone.)
  The claim that “efficient marketists” suppressed
evidence contrary to their beliefs is at variance with
Ball’s views and with the fact that in a co-authored
work with Brown (Ball and Brown, 1968) they discovered
“post-earnings-announcement ‘drift’ in prices.” (We
have been doing business in the same location for over
25 years. Doesn’t continuity count for something?)

Several interesting issues are bundled in this criticism of

“behavioral finance,” which in essence recognizes merely that

human beings, individually and collectively, behave as humans

(having psychological qualities) and not as gas molecules

(having only mass and velocity).16

The first point of the critique of behavioral finance is an

expression of Ball’s fierce belief that markets are fiercely

competitive. Accordingly, he dismisses the existence of

investors myopia, because fiercely competitive markets would

have eliminated profit opportunities that would have existed

because of myopia. Fierce competition aside (and the recent

scandal of large-scale bid-ask spread fixing on the NASDAQ

notwithstanding), this argument posits the firm belief that

economic agents must be expected utility maximizers, because if

they were not, the market would have taught them a lesson not to

be forgotten. (Note the similarity to Robert's rationale for

applying notions of chance to the market.) This notion is

precisely what is, based on the canons of prospect theory,

challenged by the results of an increasing number of

experiments. One way or another, it is a matter of ideological

belief.

The second point of criticism is based on the third

argument, and peremptorily precedes it. For the sake of

clarity, it is best to deal with the third argument before the

second. Ball contends that it is not in the interest of

business schools (e.g., the universities of Chicago and

Rochester) to promote the idea of efficiency, because “. . .

business men and MBA students have been more receptive to the

message that there is gold in the streets. . . .” This, of

course, is a distorted view of the message these schools

broadcast loudest and clearest: that markets are omnipotent and

that the best interest of society (and not just business men) is

to keep government out because it will spoil the only good thing

it did not tinker with--market efficiency.

Also, the same people who claimed to father the EMH were

quick to discover and draw attention to the existence of

anomalies, mostly in regard to the CAPM (which is, in Ball’s

mind, one clear revelation, and otherwise a testable aspect of

the EMH).17 Here, Ball does not waste an opportunity to mention

the contribution of Jensen, who as early as 1978 dedicated a

whole issue of the Journal of Financial Economics to anomalies.

There is no denying that Fama waited 14 more years to conclude

in Fama and French (1992) that the CAPM’s beta has no predictive

power.18 So, it is safe to say that the discovery of anomalies

did not do much damage to the theory, because it was never meant

to do it.

The second argument is that behavioral finance has its

anomalies. The proof, again, was discovered by Ball. The post-

announcement drift he found as early as 1968 is contrary to what

the behaviorists’ view would predict. Here, we slip into the

twilight of event studies, because Ball's argument is based on

the result of one of his early ones. We have criticized event

studies elsewhere (Frankfurter and McGoun, 1992, 1995), and have

no intention repeating here what is already part of the

literature. We say this: It is evident that both prospect

theory and its outgrowth, the over-reaction hypothesis, suffer

from their anomalies. Any number of event studies with their

suspectable and dubious results can neither prove, nor can it

disqualify any theory.

Ball’s (1996) conclusion is clearly a statement of beliefs

rather than facts:

Our models of asset pricing began with the CAPM and thus have an
accumulated history of only 30 years. With such a limited
tradition in asset pricing, we could hardly expect to have a
strong basis for concluding that security prices do (or do not)
immediately restore equilibrium in response to new information,
particularly in the presence of extreme uncertainty. Bearing
 such constraints in mind, I believe that much of the evidence on
stock price behavior does not and cannot reliably address the
factual issue of “efficiency” at this point of time. Our models
of price equilibrium and our data are not yet up to the task
(ibid., p. 11).

Although our goal in quoting Ball at such length is to show that

the existence (or lack) of “the factual issue of efficiency,”

a’la Ball, is a matter of belief, we cannot pass up the

opportunity to point out how easily misconceptions are portrayed

as facts. The 30 years Ball refers to is the total history of

what is called modern finance (financial economics). During

that time its practitioners snooped, mined, sliced, dredged,

Box-and-Jenkinsed, ARCHED, GARCHED, EGARCHED, VECMed,

cointegrated, and otherwise used, and still use, data from 1926

to 1997, which is the better part of a whole century.

As we stated earlier, there never has been nor can there

ever be a statistical test that is 100 percent conclusive. And

as long evidence can be manufactured to prove one null

hypothesis or another, what is left is a matter of belief.

Consequently, a change in a research program can occur, if and

only if there is a change in ideology. Scientific inquiry then

is immunized, to a large extent, against revolutions.

The Bard’s question remains: Were the pancakes good and the

mustard naught, or were the pancakes naught and the mustard

good? Whichever the case may be, academics are not forsworn.
IV. IDEOLOGY AND THE SOCIOLOGY OF FINANCIAL ECONOMICS

The responsibility of researchers is to contribute to

the truth either by questioning current beliefs about
what it is or by expanding its scope.--Kekes

Let us summarize the underlying principles that have

governed efficient markets research (indeed, all other research

in financial economics). Although these principles appear to be

wholly unobjectionable, their ideological basis is unmistakable.

1. An underlying cause-and-effect mechanism animates all

financial activity. Connections exist between initial
conditions and outcomes.

2. These connections are determinable and, if conditions

were to be completely specified, which in principle is
possible to do, then outcomes could be predicted with
certainty.

3. The free will of human beings, by whom and for whom

all financial activity is undertaken, can be ignored.
All relevant human behavior is governed by the cause-
and-effect mechanism.

4. All financial activity can be quantified. The logic

of statistical analysis and inference applies to all
measurements.

5. All human beings have equal access to the institutions

and systems within which financial activity is
undertaken.

The first four principles of traditional finance research

listed above clearly label it as objective. There is a cause-

and-effect mechanism underlying all natural and human activity

(ontology); it is known through the set of nomological

connections between initial conditions and outcomes

(epistemology); humans interact with each other and with their

environment in accordance with this mechanism (human nature);

and information regarding all natural and human activity can be

acquired through observations and measurements unaffected by

individual perceptual differences (methodology). In sum, the

deterministic world of finance research is not unlike that of

classical physics. It is little wonder that having endowed

markets with the same attributes as the physical universe

(timeless, impartial, impersonal, and even beautiful19 and awe-

inspiring), we should adopt a term applicable to physical

processes (efficiency) to describe them.

We are not so foolish as to accuse finance researchers of

believing that markets are an extension of the physical universe

(and as such are likely to be found in familiar form wherever

there is intelligent life in the universe);20 instead, we accuse

them of behaving as if they did.

Objectivity, of course, has its attractions. If markets

are objective and efficient, we can accept that it is not only

possible for very disturbing social inequities to coexist with

perfectly functioning markets, but that such co-existence would

be considered entirely natural. If markets are efficient, these

inequities are not the fault of the markets; the losers

themselves are to blame. After all, when a mountaineer falls to

his or her death, we do not put gravity on trial for murder.

The fifth principle implies that everyone has equal access

to the financial system. Although power struggles certainly

occur, they do so within the rational confines of the

“efficient” market-for-corporate-control. This telling metaphor

is indicative of voluntary exchange, not of the involuntary

seizure that is often characteristic of such power struggles.

Although some people may know more than others, they are just

better shoppers for information in the “efficient” market.

Useful knowledge is freely available to everyone willing to pay

its price regardless of who they are, what they do, or where

they live. The logical methodology is wholly quantitative,

because the researchers believe (implicitly or explicitly) that

their

measurements capture an objective reality that exists

independent of the observers.

This perception of the world is, of course, entirely value

impregnated and ideology driven. But this idea is not novel

with us. Schumpeter (1949) and Mannheim (1949), simultaneously,

were among the first to make it very clear that economic science

(if we can call, as Schumpter does, economics as science) is

ideology driven. Schumpeter in his presidential address to the

American Economic Association credits Marx with the observation

of interdependence between “science” [Schumpeter’s double

quotes] and the “. . . objective data of social structure.” In

Schumpter’s opinion the logical consequence of this

interdependence carries with it “. . . a new definition of

scientific truth” (ibid., p.348). This newly defined truth

affects not only the social sciences, but even mathematics and

physics. This is so, because by its influence on the choice of

problems the scientist wishes to look at “. . . scientific

thought becomes socially conditioned” (ibid., p.348). But this

is not such a problem for Schumpter because, eventually,

objective science will triumph:

Now, so soon that we have performed the miracle of knowing what

we cannot know, namely the existence of the ideological bias in
ourselves and others, we can trace it to a simple source. This
source is in the initial vision of the phenomena we propose to
subject to scientific treatment. For this treatment itself is
under objective control in the sense that it is always possible
to establish whether a given statement in reference to a given
state of knowledge, is provable, refutable, or neither. Of
course, this does not exclude honest error or dishonest faking21
(ibid., p. 351).

Thus, Schumpeter does not find anything wrong with the

influence of ideology on economics. Ideology is an inescapable

and even creative way to form hypotheses regarding the world,

and we need not fear its subjectivity because a positivist

methodology will eventually sort out the objective truth. This

is in much the same vein as Karl Popper, who in his book (1963),

Conjectures and Refutations did not concern himself with where

the conjectures came from as long as the refutation process was

rigorous.

Mannheim (1949) is much more critical and touches upon the

sociological aspects of ideological dependence:

Hence it has become extremely questionable whether, in the flux

of life, it is a genuinely worthwhile intellectual problem to
seek to discover fixed and immutable ideas or absolutes. It is a
more worthy intellectual task perhaps to learn to think
dynamically and relationally rather than statically. In our
contemporary social and intellectual plight, it is nothing less
than shocking to discover that those persons who claim to have
discovered an absolute are usually the same people who also
pretend to be superior to the rest. To find people in our day
attempting to pass off to the world and recommending to others
some nostrum of the absolute which they claim to have discovered
is merely a sign of the loss of and the need for intellectual and
moral certainty, felt by broad sections of the population who are
unable to look life in the face (ibid., p 77).

Friedman (1954) is quite clear about the moral stance he

takes, regarding the relationship between science and his set of

beliefs:

But I continue to be unrepentant in believing that its acceptance

or rejection has no bearing on the criteria by which we judge the
desirability or undesirability of the predicted implications. Am
I required to shift my moral, ethical, normative, welfare--or
whatever the word one may use for such absolutes--position
according as experience in using the hypothesis leads us to
accept, reject, or modify it? Alternatively, should my
willingness to accept, reject or modify an hypothesis about
observable phenomena be determined or altered by my ethical and
philosophical position? (ibid., p. 409).

Science is science and ethics is ethics; it takes both to

make a whole man; but only confusion, misunderstanding and
discord can come from not keeping them separate and distinct,
from trying to impose the absolute of ethics on the relatives of
science.

To put it in Humpty Dumpty’s words again: “It is a --most--

provoking--thing’” he said at last “when a person doesn’t know a
cravat from a belt!” (ibid., p. 409).

Friedman, who must have been familiar with both Mannheim

and Schumpeter is less than totally honest, and Lucas and Fama,

following in his footsteps appear to be even less so. At least

in models of general equilibrium, in general, and the CAPM–EMH,

as a special case, these gentlemen and their minions have been

using their ideological cravats (the "old school ties" that

identify where they have come from) as scientific belts to hold

up their theoretical trousers.

The answer to the enigma of the Friedman-Lucas-Fama

neoclassicism’s hegemony in financial economics thinking is,

perhaps, in the sociology of the field. By tradition, the

finance academic is trained in schools of business

administration’s departments of finance. Academic economists,

who are traditionally trained elsewhere, perhaps colleges of

arts and science, look down on their finance colleagues as their

intellectual, and even technical, inferiors.22 It is no wonder

then that a specific school that dictated economic thinking and

cross-trained finance and economics Ph.D.’s seized the

leadership in its “research program” and the editorships of the

elite publication outlets of the field.

It is true that whoever controls the publication process of

a field controls the academic fortunes of the practitioners of

the field. A.J. Liebman’s aphorism: “The press is free for

those who own it,” rings true not only for the media, but
academia as well. And one may criticize neoclassical economics,

but it is hard to deny that concerning certain things, humans

are still expected utility maximizers. Not surprisingly,

orthodoxy prevails in finance.

North (1990) is perhaps the most eloquent to suggest that a

single ideology overtaking economic thinking has its exigencies.

Although North is more concerned with the economic choices of

individuals, the same necessarily applies to the professional

choices of economists.

By ideology I mean the subjective perceptions (models, theories)

all people possess to explain the world around them. Whether at
the micro level of individual relationships or at the macro level
of organized ideologies providing integrated explanations of the
past and present, such as communism or religions, the theories
individuals construct are colored by normative views of how the
world should be organized (ibid., p. 23).

When these views translate to social policy, we close the

circle.

Financial economics of the last four decades has had no

successes with its most fundamental problems such as asset

valuation, capital structure, and dividend policy. And finance

(financial economics, or by any other name) will never climb out

of the hole it has dug itself in without considering alternative

ideologies. For this to come to pass, journal editors should be

more open minded to demonstrate that opportunities for

publication exist for “non-traditional” research, based upon

other than the neoclassical view of the world. But this is the

topic of, perhaps, another essay.

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 ENDNOTES

1. The plural of hypothesis is used because modern finance

recognizes three dimensions of “market efficiency”:
1. informational, 2. allocational, and 3. liquidity
efficiency.
2. This is so, especially in the modern mega-corporation with
tens of thousands of faceless shareholders, who often hold
ownership for a limited time only. These shareholders have
no control over the firm, which is run by managers who
control day-to-day operation as well as long term strategy.
It happens quite often that when the consequences of these
strategies affect shareholders, the managers who were
responsible for their adoption are long gone for better
compensation schemes elsewhere.

3. We select the EMH for its extraordinary intellectual impact

on financial economics. In fact, many equate what is
called modern finance with the EMH. We may just as well
have selected the different dividend policy theories for
the purpose of demonstration, which are almost without
exception based on the concept of the value-maximizing homo
economicus.
4. The basic arguments presented here upon which the concept
“pessimality” rests were developed in an electronic
bulletin-board article by Justin Schwartz.

5. Later in this section we discuss the term efficiency from

the vantage point of its evolution. Here, efficiency, is
described from the point of view of economic morality, in
the context of value maximization.

6. This was eternalized by Gustave Doré (1832-1883), the great

19th century illustrator, in his The Bible (1868).
7. In today’s re-interpretation of Smith, the monarch is
replaced by the big, evil government. Jingoistic
expressions such as “government waste,” “tax-and-spend,”
and “its your money,” are used to paint the government as
the ultimate squanderer of public money. One major problem
with this approach is that it conveniently “forgets” 300
years of evolution of the welfare state, wherein the
government has had to protect the citizenry from the very
 same free-marketeers who demand less and less “government,”
but vie for the most government privileges. A different
ideology is expressed by a ten-point statement titled
“Economic Justice for All” adopted in 1996 by the National
Conference of Catholic Bishops. These points include
proclamations, among others, as follows:

 All economic life should be shaped by moral principles.

 A fundamental moral measure of any economic system is how the
poor and vulnerable are faring.
 All people have the right to life and to the necessities of life
(food, shelter, education, medical care and economic security).
 In economic life free markets have both an advantage and limits;
government has essential responsibilities and limitations;
voluntary groups have irreplaceable roles, but cannot substitute
for the proper working of the market and the just policies of the
state.
 The global economy has moral dimensions and human consequences.
Decisions on investment, trade, aid and development should
promote human rights and pursue economic justice in economic
life.
8. We must certainly be cautious about placing too strong an
interpretation on the selection of words in a work that has
been translated from the original French into English. But
as Boness told one of the authors, he discovered the
dissertation in the MIT library and translated it from
French. Although he was a French major, Paul Cootner, who
commissioned the work, gave it to another translator to
double check the accuracy of the English text.

9. Bachelier explicitly states, “The spot buyer may be

compared with a gambler” (Bachelier, p. 27).
10. In this section, we will also consider why more than 50
years elapsed until the time Bachelier’s work was
rediscovered.

11.. In this syllogistic model, all explanations take the form

of a general law (for all x, if x has the property P, then
x has the property Q) and an initial condition (a has the
property P) from which one can draw a logical conclusion (a
has the property Q). The general law and the initial
condition explain the conclusion if it has already occurred
and predict it if it has not.
12.. There may have been other early references to efficiency
somewhere in the literature that the authors have not
uncovered. In fact, there is some confusion over the
origins of “market efficiency”; specifically, the origins
of the weak, semi-strong, and strong form classification of
efficiency. In a footnote to his original article, Fama
(1970) attributes the distinction between weak and strong
form tests to a suggestion by Harry Roberts. Brealey and
Myers (1988) attribute the definition of all three levels
of market efficiency to Harry Roberts’ unpublished paper
“Statistical Versus Clinical Prediction of the Stock
Market,” presented to the Seminar on the Analysis of
Security Prices, University of Chicago, May 1967. In
personal correspondence with one of the authors, Professor
Roberts said that the talk was never written as a paper;
however, some of the statistical ideas were included in a
paper by Pankoff and Roberts (1968) titled “Bayesian
Synthesis of Clinical and Statistical Prediction.” This
latter paper does not address the issue of market
efficiency classification.

13.. Survey articles of the EMH are plentiful in financial

economics literature; most notably by Fama (1970, 1976, and
1991).

14.. As Friedman stated, an hypothesis cannot be accepted, it

only cannot be rejected.

15.. We use the term “research program” here in the Lakatosian

philosophy sense; i.e., a dominating course of inquiry in a
certain branch of science.

16.. The bulk of the behavioral finance literature concentrates

on the application and applicability of prospect theory
developed by Kahneman and Tversky (1979, 1982), and Tversky
and Kahneman (1986).

17.. In financial economics the word, anomaly, is commonly used

to describe a temporarily inexplicable observation that,
with a little thought, can be accommodated within one’s
functionalist world view. The term, when applied this way,
suggests that the user has not even considered the
possibility that the underlying paradigm which produced the
 anomalous result is faulty. The paradigm, in effect, is
loftier than the anomaly. Within the confines of the
higher truth the paradigm represents, the anomaly is just
an aberration, a digression that should be noticed, then
simply dismissed or, if need be, tolerated.

18.. The Fama and French (1992) paper successfully discredited

the SLB model (a.k.a. CAPM), because Fama’s name has been
the tetragrammaton in finance, rather than on the strength
of its proof.

19.. See, for example, Merton (1995).

20.. The creators of Star Trek seem to have missed this point,
as markets are conspicuously absent from their universe.
Even the Ferenghi, a race lampooning economic man, hardly
have “efficient” markets.

21.. Is it just not possible that, Schumpeter the visionary that

he was, was alluding in this sentence to the deluge of
event studies to follow some two decades later?

22.. In fact, the term “financial economics” came to wide usage

around the time The Journal of Financial Economics was
launched (1972). This is, in a small way, a manifestation
how ideology expropriates language for the purpose of
controlling thought.