The basic skills that economists can bring to such meetings are a framing of developments based on the efficient markets hypothesis, which holds that financial markets will quickly incorporate all relevant information in asset prices, along with an understanding of economic fundamentals. Many commentators have associated a blind faith in efficient markets by market participants and regulators as one of the main underlying causes of the crisis.6 This seems an overly simplistic and mostly incorrect characterization. A partially correct aspect of this critique is that market discipline failed in the period before the crisis. However, this is not a true rejection of the efficient markets hypothesis, as expounded by Gene Fama, but rather a failure for incentives to be appropriately aligned.7 An efficient markets explanation usually involves a great deal of the Monday morning quarterbacking: after observing market moves that prove an analysis incorrect, there is usually a tweak to this previous analysis prompted by the market move, which does not require any substantial changes to an underlying view. To outsiders this might sound like cheating, but if the efficient markets hypothesis has validity, then unexpected market moves always contain new information over the original analysis. Indeed, the ability of individual markets to efficiently aggregate diverse sources of information most of the time is why the efficient markets hypothesis gained empirical support.8  6  See Adam B. Ashcraft and Til Schuermann (2008), “Understanding the Securitization of Subprime Mortgage Credit” Federal Reserve Bank of New York Staff Reports No.
Simon M Potter: Role of central bank interactions with financial markets Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal Reserve Bank of New York, at New York University’s Stern School of Business, New York City, 27 November 2012. *  *  *  It is a pleasure to have the opportunity to speak to you today. Having taught classes at New York University (NYU), I know firsthand the quality and analytical rigor of the students and faculty. You should all be proud of the excellent curriculum and education you are receiving here at NYU. I would like to thank Kim for giving me the opportunity to speak this evening and the public service he is providing through his leadership of the center. My remarks today will focus on the role of central bank interactions with financial markets. Because of the New York Fed’s position within the us financial system, our staff is in continuous contact with financial market participants, including investors, intermediaries, financial market utilities and analysts. Much of this contact occurs through the Markets Group at the New York Fed. For most of my professional life prior to becoming head of the Markets Group earlier this year, I had been a research economist working at the New York Fed. Like many research economists, I was trained to understand the economy with mathematical models that contain at best a rudimentary description of a financial system.