If the market's not rational, who is?
The Myth of the Rational Market tells the tale of how economists' and finance scholars' views about financial markets evolved over the past century. Actually, evolved may not be exactly the right word--there's been as much fluctuation as forward progress. My book begins with the story of Irving Fisher, the Yale economist whose work presaged most of modern academic finance and who infamously declared in 1929 that stock prices had reached a "permanently high plateau." By the 1990s, academics, central bankers and investors were repeating Fisher's errors and adding all sorts of new ones of their own.
Anyway, the book isn't meant as an exercise in economist-bashing. Even Fisher comes across as a halfway sympathetic character--if anybody in Washington had been willing to listen to his advice after his 1929 embarrassment, the Great Depression probably wouldn't have been nearly so great. (The Bernanke Fed's monetary policy approach over the past two years has been pure Fisher.) But a couple of seeming certainties that emerged from academic economics and finance in the 1960s and 1970s have been showed by experience to be mighty uncertain. One was the contention that financial market prices were in some fundamental sense correct, or at least fluctuated in a reasonably narrow band around their fundamental values. The other--and the two don't have to be linked, although they often were--was that it was relatively easy to model the movements of markets and manage the risks thereof.
If you believed these two things, then the spectacular growth in power of financial markets (at the expense of government, of corporations, of commercial banks) over the past three or four decades was great news. I'm pretty sure, in fact, that rational-market economic theories fueled this rise--although it's awfully difficult to sort out cause and effect.
Now that this financialized economy has proved to be extremely fragile, we're due for an extended period of rethinking--of financial economics, of regulation, of taxes, of how we think about economic growth (clearly, growth fueled purely by rising asset prices isn't such a great thing). I'm of the opinion that it's not as simple as, say, putting the regulators back in charge, given that there's no reason to think financial regulators are more likely to be rational and right than financial markets are. But clearly we can do better. Got any ideas?
Get rid of DSGE models and use another.
July 13, 2009 8:37 AM | Reply | Permalink
Markets are rational - except when they aren't. Markets are stable - until they're not. It is specifically for the, "except when they aren't" and "until they're not" aspects that regulation is needed. By now, most policy planners and legislators should realize that purely self-regulating markets are an academic fantasy based on principles and conditions contrary to human emotional behavior.
Rational behavior is logical and proportional to available information. It can be considered as exhibiting a linear response characteristic. Emotional behavior, on the other hand, obviously tends to be highly non-linear, that is, not logical or proportional to available information. Non-linearity in participant behavior destabilizes what otherwise would be a healthy self-regulating system. Sometimes, catastrophically so.
Human emotional behavior isn't entirely unpredictable, and can be roughly included among the available information being rationally considered by market participants. The reason, I think, that human emotional behavior can be catastrophically destabilizing is because of it's non-linear response characteristic.
Just my two cents.
July 13, 2009 9:59 AM | Reply | Permalink
I continue amazed at why the collapse of the two Bear Stearns hedge funds in July 2007 and the subsequent collapse of BS, itself, didn't raise more red flags or cause modelers to go back to the drawing boards.
How could Bernanke -- presumably basing his claims on the macroeconomic models the Fed was using - proclaim that the "subprime crisis" was not a threat to the financial system*. What do his remarks tell us about the usefulness of these models?
* "At this juncture ... the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained." Bernanke 3/28/2007
July 13, 2009 10:51 AM | Reply | Permalink
They didn't think the subprime crisis was a threat because they thought the subprime loans were insured among other reasons.
July 13, 2009 11:19 AM | Reply | Permalink
But --
If they were insured, then, the BS hedge funds wouldn't have collapsed -- that is, the fact that they did collapse demonstrated that their loans weren't insured.
July 13, 2009 11:45 AM | Reply | Permalink
Exactly, by then though, every single Wall Street business was up to their necks in subprime loans and making huge amounts of money, no one was wanted to kill the golden goose.
July 13, 2009 12:35 PM | Reply | Permalink
I forgot to add that by 2005, when AIG stopped insuring those risks, companies like Bear Sterns assumed the risk themselves.
July 13, 2009 12:38 PM | Reply | Permalink
That may explain why Bear Stearns went under. It doesn't explain why Treasury and the Fed were so unprepared for the calamity of 2008.
Reliance on a faulty model -- a model taught in almost every graduate school of economics in the country -- would, though, explain it quite well.
July 13, 2009 1:29 PM | Reply | Permalink
That too of course.
July 13, 2009 2:20 PM | Reply | Permalink
Well we might start by recognizing that market participants are intent on maximizing their own interest and where possible will exploit asymmetrical information to achieve that end. Moreover unless restrained they will also exploit power imbalances.
I think we would all be well served by having all economists study the way markets actually operated back in the Gilded Age. What happens to a market when insider trading is not only not illegal but valued as a best business practice? The old adage "What the market will bear" implies a lot more than a simple affair of supply and demand setting price, not when the vendor has the ability to control supply and influence demand.
And then after mastering the methods of Cornelius Vanderbilt they could move on back and study the history of wage setting in industrializing England from 1790 to say 1848. I am currently re-reading E.P. Thompson's 'Making of the English Working Class' and can say that the reality of the wage market in those years bears no resemblance to the sanitized market models found in text books. The notion that some Invisible Hand was busy adjusting compensation to marginal productivity is belied by facts on the ground, wage suppression was a national policy backed as necessary by the use of State force (see Peterloo Massacre).
I firmly believe that much of the problem with the classical liberal economic model is that it was formalized in a time and a place where political democracy based on universal suffrage was not only not the norm but conceived to be a positive danger to society at large. Give all workers and (shudder) women the vote and who knows what might happen. Well now we know, it gave Britain the Labour Party and the U.S. the New Deal and with them reverberations that shook old ideas about how markets should work to the core.
Caplan's book 'Myth of the Rational Voter' whose title I assume is at least an ironic inspiration to that of the book under discussion is I think at root the product of frustration. Don't the proles understand that everything was better back when the world was run by J.P. Morgan and a handful of associates?
It is no wonder that both the political and economic right look back at the McKinley Era for their ideal. No income tax, no universal suffrage in England, no popular election of Senators in the U.S., no insider trading rules, no restrictions on wage suppression. Now that is freedom!!
Prof. Thoma told me a few years ago that "Economics does not handle equity well". And after giving that some long thought I figured out why. Because classical economics does not handle popular democracy well. That is for some people in England everything was downhill after the Reform Act of 1832 with ultimate disaster delivered with Representation of the People Act of 1918, while in the U.S. it was the changes introduced with the 16th, 17th and 19th Amendments.
Damn democracy! Always screwing with this nicely designed business plan!.
July 13, 2009 12:19 PM | Reply | Permalink
Excellent response, thank you.
July 13, 2009 12:43 PM | Reply | Permalink
Very good response. I think everyone involved from a theoretical perspective (but not the main participants, obviously) failed to appreciate how much the social solidarity of the WWII and post-war period had broken down and how much damage naked, virtually unchecked greed would do. It wasn't (isn't) even rational self-interest on the part of many participants, because rational self-interest would have appreciated why it is necessary to keep the game going, i.e., why the golden goose should never be killed.
We see this repeating itself in the for-profit health care field, as Bill Moyers' show demonstrated.
July 13, 2009 1:35 PM | Reply | Permalink
Playing the market itself is not rational. Any more that expecting to "beat the house" in Vegas is rational.
C
July 13, 2009 12:24 PM | Reply | Permalink
As far as I recall, the new market theory (psychology, herd behavoir, etc) became the accepted mainstream wisdom by the mid-1990s - so it's not entirely clear to me if Justin Fox is trying to make a political point here.
Secondly, the rational market theory, as pointed out in the very first sentence of the post, is an academic theory that went on to dominate popular culture for several decades. In that regard, this is not very different from a whole host of other academic theories that were developed in a vacuum yet became accepted as Holy Grail, including various political models.
July 13, 2009 12:24 PM | Reply | Permalink
I think your recollection is faulty -- off by at least 20 years (that is, if behavioral economics is accepted by 2015).
In the event the models used that got the financial world in trouble rely on the efficient market hypothesis. And those models are still the only ones being used.
July 13, 2009 12:34 PM | Reply | Permalink
I think we have to think of market-clearing prices and market-building institutions.
National governments settle long-term capital accounts in blood or treasure.
Standardized financial instruments and exchanges can uniformly clear public and private markets domestically, long-term, but internationally, only short-term. Duh! How did we forget this?
I think classical liberals -- called conservatives in the US -- have a case against the US Treasury for financing it deficits -- until recently largely associated with the Great, World, and Cold Wars -- with borrowing rather than with efficient, uniform, progressive taxation. Only, they did not make that case, they argued for creating bogus financial instruments with a "AAA" ratings.
There was an intellectual aspect to this, in that the Chicago-school blurred the distinction between monopoly rents enjoyed by de-regulated government concession-holders such as banks, speculative gains from regulatory arbitrage, and poor, pitiful -- tends to zero -- actual profit. Suddently, wealth -- earned or stolen -- became the mathematical and magical "wealth effect". It had the virtue of re-validating the technical and moral virtue ... of wealth.
Ultimately, the distinction between plain, old market-clearing prices and asset-bubbles vanished behind torrents of magical thinking about "Law and Economics".
That suggests regulators should not substitute their "rationality" for that of financial institutions, especially since the regulators are just sycophants drawn from those firms and their various support and therapy groups.
No, a few, standard financial instruments should replace the proprietary innovations of ... contingent-fee bond-lawyers and computer wizards.
If markets are timeless and universal, then there should be no such thing as "market innovation" in the form of bizarre Anglo-American notions that it takes a creative federal judiciary or a globe-girdling navy with nuclear weapons to enforce.
July 13, 2009 1:03 PM | Reply | Permalink
Market theory is based on two false premises:
1. People always act rationally and in their best interest. If this were true, advertising would not work.
2. People possess perfect knowlege: they know the value of everything and the advantages and disadvantages of every product or service.
If human rationality or knowlege is flawed, markets will not act rationally.
July 14, 2009 2:43 PM | Reply | Permalink
It is said that the Great Depression served as a lesson for all the economists, but the history proved that this isn't at all true. I've learned it on my own, when I found myself put in the situation of almost not being able to buy cheap electronics from the store.
March 12, 2011 9:01 AM | Reply | Permalink
This information is very useful! Thanks!
Best regards, Katya, CEO of hyper v manager, iscsi virtual san
March 28, 2011 7:40 AM | Reply | Permalink
great site.
April 4, 2011 11:14 PM | Reply | Permalink
market depend on politics. some people use mortgages for bad credit or free insurance quotes for their way out.
April 5, 2011 12:02 AM | Reply | Permalink
Si vous etes interesses par le dossier, ou desirez en savoir plus, contactez-moi par mail, et je vous mettrai en contact.
Best regards,Jane, CEO of high availability servers
April 27, 2011 9:17 AM | Reply | Permalink