12 - Theory of market efficiency

Summary

Definition of exchange-market efficiency under a gold standard

Isolation of existing literature

A vast literature on the efficiency of the foreign-exchange market under a floating exchange rate exists, and the many empirical investigations are readily organized under the rubric of the theory of efficient asset markets. In contrast, studies of the efficiency of a gold standard differ radically among themselves in the very criterion of efficiency.

Interestingly, the exchange-market-efficiency literature makes no allusion to the literature on gold-standard efficiency. The reason is fourfold. First, the research on gold-standard efficiency has been neither reported nor interpreted in the context of the theory of asset-market efficiency, though it is implicitly in that tradition. Second, the gold-standard studies, unlike those in the efficient-asset-market mainstream, devote minimal attention to explicit model-building.

Third, studies of floating-rate efficiency concentrate on the current floating-rate period that began in the 1970s, whereas the literature on gold-standard efficiency is historical in nature, pertaining almost entirely to the pre-World War I dollar–sterling gold standard. Fourth, conventional wisdom holds that a necessary condition for efficiency is a free market or, at most, government intervention lightly superimposed on a market dominated by private transactors, wherefore a gold standard is by nature inefficient.

Efficient asset market

“A market in which prices always ‘fully reflect’ available information is called efficient” (Fama, 1970, p. 383). In the foreign-exchange market, the price is the exchange rate or a configuration of exchange rates.