5 - The financial crisis and market efficiency

Summary

In Europe, where the problem is mainly one of nerves, the psychological is nearly always the most important aspect of whatever takes place.

–The Contemporary Review, May 1931

We have shown that the Austrian experience of 1931 constituted a true financial crisis and was not just a pseudocrisis. Historic accounts stress very clearly the fact that the markets were surprised by the outbreak of the crisis – or, better, the crises. If this observation happens to be correct – in spite of the fact that crises of this magnitude need time to develop – then we would have to reject market efficiency for this episode. Not all the available information was incorporated into market behavior. Such evidence differs from the results of the vast majority of empirical studies of the behavior of stock markets, foreign exchange markets, bond markets, commodity futures markets, etc.

We recall from above that it was not a single crisis that occurred in Austria in 1931, but a bank failure, a banking crisis, and a currency crisis. Therefore, when we investigate whether the market predicted the crisis, we really have to ask this question separately for the different aspects of the crisis. Two episodes in particular, namely the Credit-Anstalt failure and the currency crisis, should have been reflected in market behavior before the actual events occurred. The stock market and the foreign exchange market are then the main objects of our investigations.