THE INEFFICIENCY OF WAR: Evidence from the US and UK stock markets during the Second World War

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Date:
30 Mar 2016

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One consequence of war seems to be a measurable decrease in the efficiency of the financial markets in allocating resources. In research to be presented at the Economic History Society’s 2016 annual conference in Cambridge, Robert Hudson and Andrew Urquhart examine the market efficiency of the US and UK stock markets around and during the Second World War.

They find that the markets of both countries showed substantially greater levels of inefficiency after they entered the war. But while the level of inefficiency continued in the United States into the post-war period (although to a lesser degree than during the war), the UK actually became even more inefficient in the post-war period. The contrasting experiences of the two countries perhaps reflect both the level of development of their financial markets and their different war-related experiences.

The efficient market hypothesis (EMH), a well-known theory in finance, states that at any given time, prices reflect all available information on a particular stock or market. Information does not have to be limited to financial news or research alone, it can include political events, rumours or social events.

According to the EMH, as prices respond only to information available in the market, and since all market participants are privy to the same information, no one will have the ability to make more profits than anyone else. Therefore prices are unpredictable and are said to follow a random walk.

This study focuses on the market efficiency of the Dow Jones Industrial Average (DJIA) and Financial Times 30 (FT30), two of the longest-standing market indicators in the world, around the time of the Second World War. The investigation is interesting in view of the unusual conditions prevailing during the war that might be expected to have affected the extent to which market prices were able quickly and accurately to reflect all relevant information.

To varying degrees in the two countries, governments controlled news and there was considerable government intervention in the economy with price controls and rationing. There were also distortions in the financial markets and macroeconomic management due to the needs of war financing. In addition, war events caused major political risks as well as great physical disruption and human losses.

The results of the study show that in the whole period for the DJIA, there is some evidence of nonlinear predictability indicating some level of inefficiency, while all the tests for the FT30 indicate significant inefficiency.

In the subsample periods, the researchers find that in the pre-war period the DJIA shows a quite high level of efficiency; but during the war period, starting shortly after the attack on Pearl Harbour, there is strong evidence that the market becomes more inefficient.

A level of inefficiency continues in the United States into the post-war period although to a lesser degree than during the war. This result is fairly consistent across testing procedures.

In the UK, the pre-war period exhibits less efficiency than in the United States. The FT30 is quite inefficient during the war and actually becomes even more inefficient in the post-war period.

The contrasting experiences of the two countries perhaps reflect both the level of development of their financial markets and their different war-related experiences.

These results support the idea that the US market was much more developed at the time than the FT30. That is, the US market was deemed fairly efficient up to the point of the United States entering the Second World War while the UK market was inefficient even before the outbreak of war. Therefore, the analysis is consistent with the notion that more developed markets will experience higher levels of efficiency than lesser-developed markets.

The war will have had relatively greater economic impact in the UK due to its more prolonged nature and the proportionately greater physical destruction and human casualties incurred.

In addition, economic controls were more sweeping and more prolonged in the UK. Nonetheless the markets of both countries show substantially greater levels of inefficiency after they entered the Second World War. Thus, one consequence of war seems to be a measureable decrease in the efficiency of the financial markets in allocating resources.

ENDS

The Inefficiency of War: Evidence from the US and UK during WWII

Robert Hudson, Hull University Business School: robert.hudson@hull.ac.uk

Andrew Urquhart, Centre of Computational Finance and Business Analysis, Southampton Business School: a.j.urquhart@soton.ac.uk

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