The Myth of the Rational Market

Among the reasons offered for why the economy has been so prone to bubbles recently — and why the current recession has been so severe — is that the models mathematicians and economists devised to manage financial risk were inadequate to the task. Unlike with insurance against natural disasters, the act of financial hedging can influence the chances that what’s being hedging against will actually happen. Despite this and other flaws, the models nonetheless lulled investors into complacency over the safety of their highly leveraged bets on a variety of securities and derivatives that were not only far riskier than was understood, but proved to be correlated in unanticipated ways.

How did these large-scale investors, entrusted with astronomical sums, become so deluded? While it is tempting to chalk it up to simple hubris, Justin Fox’s The Myth of the Rational Market suggests other possibilities, rooted in doctrinal schisms among economics professors, business schools, and ultimately politicians about the social role of markets in disseminating and distributing information.

As Fox details in the book, which amounts to an intellectual history of markets in the 20th century, libertarian-minded economists who wanted to curtail government regulation were able to find common cause with math-oriented finance experts seeking elegant, unencumbered formulas for valuing enterprises and derivatives. Both benefited from an ideological premise they came to share: that market movements are at once both random and perfectly just, and that these traits reinforced one another and canceled out the risk of extreme, disruptive economic events. Empiricist modesty gave way to ever-more confident attempts at asset pricing by formula, leading ultimately to the assumptions and models — things like the Value at Risk model, the Black Scholes options-pricing formula, the Gaussian copula — that failed investors so spectacularly in 2008.

Fox, a blogger and economics columnist for Time, traces the course by which economists arrived at its near-paradoxical hypothesis about markets, recounting the objections that they had to overcome and hinting at the financial and political motivations they had for being so persistent in their beliefs. Government regulation of finance — reinterpreted in light of the hypothesis as distorting the market’s perfection — was rolled back, and the unrestricted financial industry was able to seize a higher and higher percentage of the profits earned in the American economy, which in turn helped it augmented its political clout, as Simon Johnson, a onetime economist at the IMF, detailed in “The Quiet Coup” (Atlantic, May 2009):

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions…. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

Fox charts the course of this migration, but considering the economic catastrophe now unfolding, he remains stubbornly neutral in his account; instead of critique, he offers a blizzard of names, institutions, and economic journals. At times, his insistence on tracing the pedigree of the economists whose work he mentions becomes distracting, seeming like a stream of academic gossip about who was hired by whom to work at which university and which economics department had the highest profile.

The slurry of names sometimes muddles what is otherwise a lucid synthesis of the ideas that went into what Fox calls the rational market: the ideal of homo economicus, or humans as hyperrational economic actors; the efficient-markets hypothesis, which assumes that asset prices always already reflect the impact of information pertinent to them; the “random walk” theory that argues prices movements are arbitrary and can be plotted on a bell-curve distribution; and the faith in what Milton Friedman dubbed “positive economics”, the notion that radically simplifying assumptions in economic models can be justified after the fact by evaluating the usefulness of their predictions.

Fox’s account of the rational market revolves around the long-held dream of discovering a method to pin down the intrinsic value of an asset — what it should trade for, so that mispricings could be systematically exploited by investors and the potential for bubbles negated. Unlike Marx, who, drawing on Ricardo, tried to trace value back to the notion of socially necessary labor, 20th century economists start from the premise that markets alone reveal the “true” value of assets by aggregating all the information gathered by all the various parties participating in exchanges and transmuting all that data into a simple, immediately comprehensible metric: price.

Austrian economist Friedrich Hayek wrote the classic exposition of the idea in The Use of Knowledge in Society. Hayek noted that “the ‘data’ from which the economic calculus starts are never for the whole society ‘given’ to a single mind which could work out the implications and can never be so given.” And economic conditions are changing by the moment, requiring different responses and different calibrations of potential future returns. Therefore, no group of bureaucrats can ever be in a position to plan economic development, à la a Soviet Five-Year Plan. Instead, a “rational economic order” requires markets, which serve as mediums of information exchange as well as the exchange of goods.

It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

Moreover, the market allows participants to make economically sound decisions without particularly knowing why. “The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.”

But this seems to present a conundrum. Market participants are expected to use their unique and specific knowledge to take advantage of errant prices and thereby correct them. In financial lingo, this is known as arbitrage. But at the same time, they must accept the information that a price is an accurate reflection of conditions they can’t be aware of and aren’t qualified to second guess. So they are in the position of having to trust the market’s wisdom while simultaneously correcting it. They have to understand their own limits and constantly exercise subjective, contingent judgment.

To his credit, Hayek recognized this: “Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people’s knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain.” In other words, economists must be careful not to assume away the gap between the isolated, subjective views on the economy and the unknowable totality of objective reality, or to ignore the perpetual need for individual judgment.

But as Fox’s account so punctiliously reveals, influential economists and finance scholars would repeatedly ignore Hayek’s warning in favor of pursuing financial “innovation” that has since been proven specious at best. They chose to overlook the psychological vagaries involved with market behavior — the Keynesian concern with investor confidence and “animal spirits” as well as the decision-making anomalies later taken up by the behavioral economics movement, which Fox covers at the end of his book — in favor of formulas built on the presumption that investors always acted with predictable rapacity and efficiency. Perfect judgment was conveniently regarded as automatic.

Preventing Fantasy from Eclipsing Reality

Image (partial) found on Zimbion.com

Heaven forbid we take an interest in people. That might interfere with the chances to ruthlessly exploit them.

So, given that pool of keen, deep pocketed and ultrarational market watchers (“infinitely selfish and infinitely farsighted,” as statistician Henri Poincaré put it to economist Léon Walras in an early critique of the idea), any opportunities to beat the market would be systematically eliminated by traders in the process of profiting from them. This, economist Eugene Fama argued, “assured that actual market prices are, on the basis of all available information, best estimates of intrinsic values.”

The perfection of the market would then trump any psychological peccadillos of individuals or any parochial disgruntlement with economic outcomes. As finance scholar Merton Miller explained, the stories of what prompts individuals’ actions may turn out to be “too interesting and thereby distract us from the pervasive market forces that should be our principal concern.”

Heaven forbid we take an interest in people. That might interfere with the chances to ruthlessly exploit them. What the ideology of efficient markets does, then, is transform market outcomes and reconstitute them as the natural order of things, a status quo that it would be perverse to try to fight. And by marginalizing individual decision-making and purposely ignoring people’s stories, the efficient-markets hypothesis abrogates human sympathy. As Fox puts it, “The market was rational. Who cared about individuals?” Regardless of whether this attitude helps anyone beat the market (in its strictest form, the efficient-markets hypothesis suggests that it’s impossible), it is exceedingly useful politically for justifying inequality. And as Fox explains, it helped rationalize the more egregious excesses with leveraged buyouts in the ‘80s, which saddled corporations with debt and prompted them to layoffs and factory closings in the name of dubious shareholder value.

As many skeptical economists came to point out, the microfoundations of rational markets couldn’t be so easily ignored. The notion of perfect markets assumes no obstacles to instantaneous arbitrage, but there are in fact many barriers. For instance, there are information costs incurred in unearthing information and interpreting it. And there are transaction costs: Those with significant insights must also have access to enough money to make their price-changing bets, though their very certainty that the market is likely to make potential lenders skeptical of them.

Also, if actual market prices are already the best estimates of true value, what motivation is there for anyone to participate in markets and try to affect them? If all the profit opportunities are immediately arbitraged away by ever-vigilant investors, no opportunities will remain to motivate them to continue to pay attention to the financial world. If markets are already perfect, why bother?

It turns out there must be dumb money in markets creating the anomalies and profit chances for the smart money. In early versions of the efficient-markets hypothesis, such investors were presumed irrelevant, since their lack of skill or knowledge meant that they wouldn’t be able to participate in markets for long. But as efficient-markets proponent Fisher Black was forced to admit, unskilled traders were necessary to create the opportunities that kept better-informed traders interested. Once these irrational investors are not assumed away by theory, they present insuperable problems.

The smart traders have no clear method by which to distinguish authentic price signals from market “noise”, the unpredictable movements caused by the uninformed investors. As Fox notes, the noise they generate “not only keeps prices away from their fundamental values. It makes it impossible to tell what those fundamentals are.” And with that, the primary ideological justification of the rational-market theory is lost.

If unregulated markets reveal nothing — if a stock price doesn’t reveal how well a company is being managed, for instance — what good are they? What sense does it make to continue to ignore individual psychology, and to fight against regulation that might temper the systematic errors in investors’ reasoning that behavioral economists have uncovered?

Perhaps most damning for the efficient-markets hypothesis, though, is not a logical refutation but an ethical point Keynes made in the General Theory, well before the “rational market” became hegemonic. “The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”

The rational market theory both denies the possibility of “outwitting the crowd” and insists upon it. The belief that the market always allocates capital in the best of all possible ways automatically authorizes the desperate short-term strategizing and the reckless use of leverage to take advantage of the tiny discrepancies that aren’t even supposed to exist.

Preoccupied with “beating the gun”, the banking industry ends up neglecting long-term economic development in favor of playing zero-sum games of financial musical chairs with bad assets. What is good for finance ceases to be what is good for a nation; the pursuit of profit no longer aligns with the discovery of where a society’s resources should be directed, or where further development is needed.

What can be done to prevent the rational-market fantasy from eclipsing the real economy again? Economist Barry Eichengreen offered this hopeful prediction in a recent article for The National Interest:

The late 20th century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy. In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. (“The Last Temptation of Risk”, 30 April 2009)

Whether or not this comes to pass, the rational market and the fantasy it represents — the ability to use esoteric math or some other magical means to remove the need for human judgment and human frailty from human endeavor — will probably be with us forever.