The Myth of the Rational Market

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How silly we were to believe that investors always acted with predictable rapacity and efficiency.

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Publisher: HarperCollins
Length: 400 pages
Author: Justin Fox
Price: $27.99
Format: Hardcover

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.

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