The Myth of the Rational Market

by Rob Horning

20 May 2009

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Preventing Fantasy from Eclipsing Reality

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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.

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