THE current Western financial crisis has brought down a house of cards built on the much-worshipped "efficient" markets, but many Chinese savants appear heedless, worshipping "efficient" markets as usual.

On February 6, Xinhua news agency reported that all the Chinese economists and legal scholars it had interviewed recently believed there couldn't be shadow banking - underground fund raising, in particular - in an efficient market.

Xinhua was referring to the case of Wu Ying, a thirtyish woman sentenced to death by a local court in Zhejiang Province on January 18 for amassing of 770 million yuan (US$122 million) between 2005 and 2007 outside the legal banking system. She made extravagant promises of high returns to investors, saying in effect, "Lend me one million yuan and I will give you three million in three months."

"In the view of the economists and legal scholars we've interviewed, the case of Wu Ying will not present itself either in a command economy or in an efficient market economy," Xinhua reported. "To all those experts, the case of Wu Ying occurs only in an economy in transition."

The case is now in the hands of China's Supreme People's Court, which said on February 14 that it would weigh the case carefully since it involves a gargantuan amount of money raised from the shadow banking market.

I'm not interested in being a soothsayer of Wu Ying's fate. What matters is the intellectuals' uninformed embrace of the "efficient markets hypothesis" (EMH) that defined, developed and destroyed Western economies in the 20th century.

Xinhua did not name all those pundits, and no informed reader would infer that all Chinese scholars subscribe to the EMH, but Xinhua did show that it has powerful Chinese converts who see freer markets as China's future economic way.

These converts are right in criticizing a command economy, where the government corners the market, but their logic goes haywire when they say the market is efficient, that is, if unregulated, the market "self-regulates" and basically delivers all the right outcomes.

Yves Smith, author of "Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism," explains why there's no such thing as an efficient market under the sun, and why shadow banking thrives even in an unregulated market.

Paul Samuelson (1915-2009), the first American to win the Nobel Prize for economics, and Eugene Fama (1939-) of the University of Chicago developed the EMH by proposing that prices of traded securities fully reflect all information about them. But in reality, the assumption of perfect knowledge among all investors is unrealistic: in sales of assets, one party often knows more about the market than the other party.

Flawed assumptions

The Efficient Market Hypothesis belongs to the neoclassical school of economics, which is laden with debatable assumptions, the most flawed being that no one has more information than anyone else in a free market. The reality is that possession of necessary knowledge is asymmetrical.

In fact, before the ascent of neoclassical economics - the quantitative descendant of classical economics represented by Adam Smith - around the 1940s, the US had already tried unregulated securities markets, "and the result was periodic crashes, culminating in the spectacular 1929 meltdown," Smith writes.

The Great Depression of the 1930s led the US to tighten regulation of financial markets, notably by requiring full information disclosure and by insuring bank deposits. The Glass-Steagall Act was passed to separate commercial banks from investment firms.

But the public's financial memories were short. In the 1980s and 1990s, US federal lawmakers phased out the regulatory wall between commercial banks and securities firms. In 1999, they repealed what remained of the Glass-Steagall Act.

And the result?

"Widespread acceptance of the phony precepts of financial economics and neoclassical economics helped bring about the (current) financial crisis by endorsing policies and practices that allowed financial firms to exploit customers, shareholders and taxpayers on a scale heretofore seen only in banana republics," the author says. "Data do lend support to the notion that the shadow banking system was the main culprit in the meltdown."

The shadow banking system here refers to the uninformed trading of derivatives related to mortgage loans, many of which were of sub-prime standards. The buyers and sellers of collaterized debt obligations and credit default swaps basically bet that America's housing prices would keep rising and that the quality of mortgage credit would remain stable.

Empty promises

It was a much more complex shadow banking system than what was discovered in Wu Ying's case. Wu didn't know about securitization and derivatives, she just snapped her fingers and gave empty promises. But in both cases, the victims had no way to work out what was really happening in the game.

Wall Street has a much freer financial market than China, but it also has a much riskier shadow banking business than China. Which means that greater freedom to borrow and lend will not wean China from shadow banking that is by nature speculative.

As the late legendary economist John Kenneth Galbraith notes in his book, "A Short History of Financial Euphoria" (1994), financial speculation and collapses are built into a free-enterprise system, or a free market. "The circumstances that induce the recurrent lapses into financial dementia have not changed in any truly operative fashion since the Tulipomania of 1636-1637," Galbraith wrote.

In his opinion, how the drama plays out never varies: when it comes to money, most people are blind to lies.

In a free-enterprise world, he explains, money is the accolade of a life well lived. The more you have, the smarter you must be. Every have-not must defer to those haves and their speculative ventures. Only after a crash does their supposed intelligence prove to be specious. But public memories are short. A few years or decades after the crash, gullible masses line up to throw money away on the next big thing.

Galbraith ended his 1994 book with a question: "When will come the next great speculative episode and in what venue will it recur?" Now you know the answer.

Wu Ying's illegal fund raising may not amount to that kind of a big thing, but like any other speculative episode, it has less to do with the so-called lack of a free market than with human nature set loose in a society where pursuit and possession of vast amounts of money are proof of a life well lived.