I recently had the pleasure of reading Justin Fox's new book The Myth of the Rational Market. It offers an engaging history of the research that has come to be called the "efficient market hypothesis". It is similar in style to the classic by the late Peter Bernstein, Against the Gods. All the quotes in this column are taken from it. The book was mostly written before the financial crisis. However, it is natural to ask if the experiences over the last year should change our view of the EMH.
It helps to start with a quick review of rational finance. Modern finance began in the 1950s when many of the great economists of the second half of the 20th century began their careers. The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.