Justin Fox on Regulatory Reform and Market Irrationality

The financial crisis and global recession has spawned a bevy of newly published polemics examining all aspects of the meltdown and its sources. Few have managed the perspective and insight of Justin Fox's "The Myth of the Rational Market". An engaging history of the minds behind the financial innovations of the past century, Mr Fox's work has also sparked a serious discussion of the state of financial economics as understood by market participants and regulators. Mr Fox is the business and economics columnist for Time, and he co-authors the Curious Capitalist blog at Time.com. We asked him a few questions this week about irrationality, how he'd handle regulatory reform, and whether there's any good alternative to reliance on markets.

FE: Given limitations to market rationality, how should we approach the use of market signals (like, say, the use of CDS spreads by regulators, or market interest rates by Fed officials) in policy making?

Mr Fox: That’s a hard one. I get the argument for moving away from dependence on the obviously compromised rating agencies and toward a system where CDS and other credit spreads are used by regulators to weight risks. But then, I got the argument for moving toward more mark-to-market accounting, and it seems pretty clear that hasn’t turned out to be an entirely brilliant idea. I guess my main thought here would be, go slow with it.

FE: Where does portfolio theory and the idea of risk diversification stand in light of the correlations we have seen between asset classes during the crisis?

Mr Fox: The less pressure you put on portfolio theory, the better it holds up. That is, if you use it as a loose guide to diversification, it still works pretty well. If, however, you rely on it to manage the risks of a highly leveraged portfolio, you’re probably increasing the likelihood that you’ll end up toast. It’s the same way with efficient market theory: As a very loose description of how the market works, it’s not totally wrong. But as soon as you start depending on prices being right, you get into trouble.

FE: You write that "[Milton] Friedman saw the Depression as the product of a Fed screwup--not a market disaster--and convinced himself and other economists (without much evidence) that speculators tended to stabilize markets rather than unbalance them." This seems like a remarkable accomplishment given the market's stunning rise to 1929 and the manias and bubbles which predated the Depression. How did an efficient markets hypothesis ever get off the ground in light of this history?

Mr Fox: I think the arrival of math and statistical theory in mainstream economics—which began in the 1930s in the U.S. and really took off after World War II—played a big role because it was just so much easier to model a rational expectations equilibrium than an economy marked by manias and bubbles. Also, the passage of time played a big role. Friedman was old enough to the remember the Depression, but was only 17 when the market crashed in 1929 and wasn’t exactly keeping a close eye on Wall Street. Just about everybody else involved in this intellectual movement was younger than he. One of the landmark papers by Franco Modigliani and Merton Miller actually addresses this issue head-on: Yes, “speculative bubbles have actually arisen in the past,” they wrote in 1961, but they “do not seem to us to be a dominant, or even a fundamental, feature of market behavior under uncertainty.” So assuming that prices were set rationally was “useful, at least as a first approximation, for the analysis of long-run tendencies in organized markets.” They were right: It was useful. But it meant that an academic approach based on this assumption wasn’t likely to have much of anything useful to say about bubbles and crashes.

FE: To what extent does questionable rationality extend to goods markets? At what point in course of normal buying and selling do expectations about what others are likely to believe about price movements begin to influence current prices? Why do we have bubbles for single-family homes but not (that I'm aware) for Toyota Corollas?

Mr Fox: For a long time, a lot of people in academic finance had this idea that financial market prices were more reliable and rational than those in goods markets, because financial markets were more liquid, prices were less sticky, etc. But when you think about what participants in financial markets are actually doing—”anticipating what average opinion expects the average opinion to be,” as Keynes put it—it’s pretty clear that there’s going to be a tendency toward herding and bubbles that is far less likely to be found in markets for eggs or SUVs. And in the first half of this decade the real estate market, which has aspects of both a goods market and a financial market, went totally financial.

FE: Burton Malkiel concluded a recent review of your book by saying, "With "The Myth of the Rational Market" Mr. Fox has produced a valuable and highly readable history of risk and reward. He has not, however, been able to bury the hypothesis that our securities markets are usually remarkably efficient." How do you build a regulatory system around this notion? (And do you accept Malkiel's assertion?)

Mr Fox: Depends what you mean by “efficient.” If you just mean securities markets are hard to outsmart, which is what Malkiel’s getting at, then he’s right. I haven’t been able to bury that notion, and I wouldn’t want to. If you mean that the prices prevailing in securities markets are always rational and reasonable, which really is what lots of finance professors used to believe, then that’s pretty well dead and buried by now. The upshot for regulation is that financial markets go crazy, but you can’t rely on regulators knowing when markets are wrong. Which seems to point toward doing roles that would both temper the market’s moves and reduce the risk of collateral damage there’s a crash. Restricting leverage seems to be the most straightforward way to do this—as we’ve learned over the past decade, a bubble based on equity (the dot.com insanity) causes a lot less trouble when it collapses than one based on debt (real estate).

This article originally appeared on The Economist.com

Comments

[Ferdinand E...:]

Justin Fox is a lot smarter than I thought he was when he was telling us about oil. Let me also mention that any paper by Franco Modigliani and Merton Miller is worth reading - but NOT one on the Modiglicani-Miller hypothesis..

Jun 28 09:32 AM

[Glen L.:]

I probably should read his book before commenting, but Fox is picking on a bogus defender of rational markets with his criticism of Friedman. Friedman was right about FED policy creating the Great Depression, but he blamed the wrong policy -- failure to inflate the money supply after the stock market bubble burst and before thousands of banks failed. Murray Rothbard nailed the FED correctly -- i.e., it created the stock market bubble in the first place, via easy credit policy -- in his book "America's Great Depression".

Bernanke is acting out the fantasy he proclaimed to Friedman himself, when he agreed the FED had made the mistake of not inflating in the 1930's, and promised that it would never make the same mistake again. Unfortunately for all of us, he's simply making the Friedmanite monetarist mistake.

Jun 28 01:38 PM

[Valley Boy:]

Ryan, we need to hear more about the myth of the Washington policy makers knowing the answers to our financial problems.

Jun 28 11:46 PM

[dcb:]

I think quants and hedge funds going in and out all day has made the market mush more irrational. If you actually have to take a position, you make a more rational choice.

Jul 03 08:14 AM

[dcb:]

WTF. before cetin you talkd about the goldi locks economy on your blog and how it was on it's way back despite what anyone else or evidence said to the contrary. now your blog is different. Seeing the light of rationality and reason, or just working to drive up web traffic. The worst thing about folks like you is that they will say what ever is in fashion in order to be "popular".

Remember employment didn't matter, household debt levels didn't matter, fed and administration people doing great job, there was no market manipulation, all was Ok because the market was going up, and the markets was the only thing that mattered in your universe. income disparity? no problem, let the people starve who can't make an honest wage wall the folks on wall street make billions for pushing paper. this is the cetin I remember.


On Jul 03 05:09 AM Wallstreetcrash wrote:

> yea the market is an irrational conspiracy
> good articles : makeitbrief.com/avupq

Jul 03 08:21 AM

[inflate me:]

sdfsd

Jul 03 09:32 AM

[Chuck Carne...:]

It's so gratifying to see more rational thinking regarding Modern Portfolio Theory. The efficient market hypothesis had to be added otherwise the attempt to relegate analysis to mere statistics wouldn't hold water. A more rational view of a market that is always seeking efficiency is more intelligent. This is better known as the law of supply and demand.

The real problem is that MPT and it's reliance on statistics offers no predictictability capability. Fundamental analysis based on cash flows etc. does. It's time we returned to what I call "Ancient Porfolio Reality." Where investing decisions are being made based on the time tested principles of Business,Economics and Accounting.

Good article. I missed this book , I will fix that today.

Jul 03 09:35 AM

[Market Holiday:]

.

Jul 03 10:00 AM

[Steve in Gr...:]

The bubbles we have seen burst in 2000 and 2007 were both primarily due to money supply inflation by the Fed (with a little help from Barney Frank, Chris Dodd and Jimmy Carter's Community Reinvestment Act).

Market irrationality and disruption can be substantially attributed to government interference in the markets.

The market might not be perfect, but it is way better than government regulation. We need to have market forces setting the money supply.

Jul 03 05:02 PM

[Crocodilian:]

"Efficient" and "Rational" do not mean the same thing.

The market is demonstrably efficient. This means that it discounts information known at the time, such that no party without the benefit of non-public information has a statistically significant probability of outperforming the market. That's what the numbers reveal. Despite the massive numbers of professional managers, no more than a handful outperform the market -- the same number of outliers that chance would predict. As Burton Malkiel pointed out, if you get a million people flipping coins, someone's going to flip "heads" many times in a row-- that doesn't make him a "genius coin flipper", that's just the way probability operates.

"Rational"? If by that one means "making appropriate allocations between sectors in society", then the answer is "no"-- but few have ever claimed that it was. Making allocations of resources for the benefit of society is a political act, a choice between values ("more stuff now" vs "more tanks" vs "more healthcare later") that are not part of economic calculation.

Jul 04 01:02 PM

[Smiddywesson:]

The markets are alive. I don't see the need for their steady state of rationality. Is your wife always rational? Are you always rational. Just because you cannot measure the change in state between wisdom and folly doesn't mean the markets must always be the same.

Just as the old saying goes "The trend is your friend, until it's not", the Markets are rational, until they're not.

Surowiecki, in his book, The Wisdom of Crowds, argues that the herd is capable of surprisingly accurate collective decisionmaking until some outside force impairs its ability to access information. He opined that this usually occurred when information is limited, or it is deliberately ignored, such as what happens when the crowd becomes overly attached to a person, a story, or a product.
I learned from you, my fellow bloggers, that this is more likely to occur in some markets, like financial markets, than in others, and that the damage done is greater in markets based on debt (like real estate) than on equity (tech stocks).

Anyway, I would like to suggest a third position to the rational/irrational debate. I disagree with the old adage that the crowd is always wrong. In fact, the markets are always rational... except when they're not. This happens during the big turn arounds when the herd is seized by collective greed or fear. It is at those times that there are not enough counter emotions to cancel each other out and create a rational market. Instead, everyone being on one rail of the ship, they are all thown into the sea together during the capsize which they created.

Jul 04 02:19 PM

[untrusting ...:]

Steve,
Could not disagree more with you. The bubbles in 2000 (dotcom) and 2007 (mortgages/derivitives), were in large part caused and driven by massive fraud in the securities markets. The dotcom, Enron, Worldcom, etc frauds were all devised by the private sector. The massive fraud in mortgages and securitization was devised by the private sector being mortgage brokers, appraisers, rating agencies, investment banks, etc. The lack of effective regulation, the massive fraudlent profits/compensation, and the lack of effective prosecution is what enabled these hughly profitable fraudlent bubbles to develop. While it may be argued that money supply/liquidity provided the fuel for these bubbles, it is totally false to state that the government caused these bubbles. The government did not enable the fraud by the Enron energy traders, or the cooked books by Worldcom/Arthur Anderson, or the lies and deceit by Wall Street investment banks and their analysts about the dotcom worthless companies. The private sector in their greed, unethical conduct, and dishonesty directly caused all of these. Likewise, the government did not fraudently appraise all the subprime, AltA, etc mortgages, or nodoc loans. Nor did the government fraudently rate DDD mortgages as AAA like the private sector ratings agencies did. Nor did the government securitize all the worthless mortgages and offload them to worldwide investors as did the investment banks. Nope, these were purely massive frauds initiated by the private sector purely out of greed and self-interest without regard to the misrepresentation and dishonesty involved. Nor did the government enter into massive fraudlent insurance/derivitve contracts such as AIG did without the ability to pay the "insurance" they fraudently collected premiums on .. no AIG, a private sector company, did that out of gross incompetence and pure greed. It is the private sector that paid for and lobbied heavily for removal/omission of regulations such as Glass-Stegal, no regulation on derivitives, exemptions on hedging/speculation, and literally hundreds of other regulations that benefited themselves and put the rest of the public at extreme risk. In fact the exact opposite of what you state is true ... it is the lack of government regulation and lack of government interference/enforcement that has enabled Wall Street to cause the trillions of dollars in losses in 2000 and 2007.


On Jul 03 05:02 PM Steve in Greensboro wrote:

> The bubbles we have seen burst in 2000 and 2007 were both primarily
> due to money supply inflation by the Fed (with a little help from
> Barney Frank, Chris Dodd and Jimmy Carter's Community Reinvestment
> Act).
>
> Market irrationality and disruption can be substantially attributed
> to government interference in the markets.
>
> The market might not be perfect, but it is way better than government
> regulation. We need to have market forces setting the money supply.

Jul 04 10:11 PM

[Steve in Gr...:]

Dear Untrusting, The primary reason for the latest bubble was the increase in the money supply engineered by the Fed in response to the dotcom bubble. The money had to go somewhere. This time it went to real estate and the stock market. In real estate, we can thank Barney Frank, Chris Dodd, Franklin Raines and Jimmy Carter and his Community Reinvestment Act for the loans to non-creditworthy borrowers.

I wonder where the latest massive money supply increase engineered by the Fed will go? I suppose that is the goal of everybody on SA, to guess where the next bubble will be.

Please, please give me an example of effective regulation. I know this is a challenge. It is much easier to give examples of ineffective regulation. My favorites lately are 1) the SEC auditrix who audited Madoff and found everything OK (pure laziness and stupidity) and 2) the insider trading at the SEC (government drones using insider information to enrich themselves).

Do you think working for the government automatically cures one of greed and stupidity? Sorry, but it just gives more scope for those impulses and less payback.

People are people, greedy, fearful and willing to cheat. This includes government employees.

Less regulation, more freedom equals more prosperity.


On Jul 04 10:11 PM untrusting investor wrote:

> Steve, Could not disagree more with you.

Jul 05 06:40 AM

[spontsymm:]

Who sinned first? Nixon who killed the gold standard that made it OK to print our way to prosperity. Glass Stegal deregulators who ultimately enabled the whole chain of debt repackaging and legalized counterfeiting, or the barney franks of the world ratcheting down lending standards to try and help working folk own one of the glut of homes on the market built on easy credit from the fed? I believe in the linear time line it was the rampant financial de regulators that made it OK to shovel debt burdens instantly off of balance sheets via the alchemy of securitization and sketchy derivative products to hide/socialize systemic risk. This financial crisis transcends the old and uninspired ideology of lazy fair vs. govt regulation. This crisis grew from the cracks in the foundation that the incestuous investment banks intentional inflicted. Any organization that is too big to fail is too big to exist in an efficient market. Unfortunately breaking up our overweight corporations flies directly in the face of lazy fair enthusiasts, therefore has problems gaining traction in the "govt of any kind in the devil" crowd that seems to embrace a new form of financial anarchy and the resultant fiefdom it creates.

Jul 05 11:40 AM

[taojaxx:]

Funny how the debate gets hijacked by pro/anti regulation ideologues.
Markets do not exist separately from market participants and reflect their rationality/irrationality of the moment. There is no market steady state of any sort: it is an ongoing process where supply/demand most of the time tends to rationally discount all known information and some of the time simply discounts the fad of the moment, hence the bubble with positive feedback trading (the higher it goes, the more I buy).
As to the dotcom being based on equity and real estate on debt hence the difference in impact, that's not true: dotcom was based on debt as well (ever heard of margin accounts?). The dotcom simply hit household as banks didn't own inflated stocks and only marginally financed stock speculators. Real estate hit banks' mortgage portfolios big time and their subprime holdings, crippling the financial sector and cutting off credit to the whole economy. It's like being hurt in the arm or leg (dotcom) and being hurt in the lungs or heart (subprime).

Jul 05 09:55 PM