Don't confuse free enterprise with a questionable theory about securities markets















We've written about our insistence on using the term "free enterprise" rather than "free markets" in previous posts, such as this one and this one.

While this may strike readers as a somewhat cranky or esoteric distinction, we believe that in fact it is an incredibly important distinction, but one that people overlook all the time.

The problem arises when people confuse a certain theory about the efficiency of securities markets with the system of free enterprise capitalism (often referred to somewhat confusingly as "free market capitalism" or simply "free markets"). The two are simply not one and the same, and yet proponents of the efficient market theory often act as though they were!

We believe the efficient market theory is hogwash. As we explained in this recent post, a popular way of explaining this theory is that a blindfolded chimp throwing darts at the stock pages is as effective as selecting stocks using dedicated fundamental analysis. Efficient market theory proponents believe blindfolded chimps are just as effective because their theory says that the market is so good at pricing securities, nobody else should bother questioning its pricing decisions. This theory, or some modification of it, forms the foundation of all of so-called "modern portfolio theory," which we believe to be largely hogwash as well.

Proponents of the efficient market hypothesis, however, often use the success of free enterprise as a supporting argument, even though the two concepts are not at all the same. For example, one modern portfolio theory supporter said in a debate that the only people who don't agree that "markets work" are "the North Koreans, the Cubans, and the active managers." By saying that, he is conflating those who disagree with free enterprise capitalism (the rulers of North Korea and Cuba) with those who disagree with the efficient market hypothesis (the active portfolio managers, who don't believe that blindfolded monkeys can do it just as well).

We have rebutted this argument several times, including here, here, and here. Perhaps the best way to clear up the issue, however, is to simply point out that there is a very real distinction between securities markets (which serve a very important function of allocating capital and providing liquidity, but which sometimes get prices very very wrong) and the system of free enterprise (which enables people to innovate and add value to the best of their ability and which has brought about tremendous advances for humanity wherever it is tried).

The only real connection between the efficient market theory and the concept of free market capitalism is in the word "markets," which is why we prefer the term "free enterprise" (another reason is that it puts the emphasis where it belongs, on entrepreneurial innovation). When you look at it that way, it isn't a small distinction at all.

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