Keynes and the efficient market hypothesis

Over at The Money Illusion, Scott Sumner has posted a number of blog entries about John Maynard Keynes as an investor and how it informs the debate about efficient markets:

Far from refuting the efficient markets hypothesis (EMH), the story of Keynes’ investments actually supports the buy and hold recommendations of those who adhere to the efficient markets view, “stocks for the long run.” He did best when he didn’t try to time the market, and did poorly when he engaged in fancy speculative gambles during 1928-29.

It seems to me that one of the errors that many people (including some academics) make when discussing market efficiency is to assume that the hypothesis requires that all participants in the market are rational. Since this postulate so obviously contradicts empirical reality, it is argued that economic approaches associated with market efficiency (such as New Classical Macroeconomics and Real Business Cycles) must be flawed as well. But does the efficient market hypothesis really require such a strong postulate? Is it not enough to propose that rational individuals take advantage of the profit opportunities created by those who make mistakes?

Another flaw in discussions about rationality and efficient markets is that little attention is being paid to the question whether it can be rational to be irrational. As Bryan Caplan has argued in his book The Myth of the Rational Voter: Why Democracies Choose Bad Policies, the average  voter in a mass democracy does not have a strong incentive to be rational because irrationality is basically costless. Thus Caplan writes “irrationality, like ignorance, is sensitive to price, and false beliefs about politics and religion are cheap.” Linking rationality to incentives in this fashion offers the prospect for a reformulation of classical economics that can lead to improved insights into the observation that we see so much variability in the applicability of the strong rationality postulate.

Of course, the case against efficient markets is of little practical interest unless it can be argued that something meaningful can be done about it. Government intervention seems to be of little use if the incentives that shape and maintain irrational behavior apply to collective choice as well; instead, we should expect them to be worse for reasons that are unique  to government (monopoly, the absence of price mechanisms, the prospects of redistribution etc.)