Book Review: The Myth of the Rational Market
Man, economists tell us, is a “utility maximizer.” He seeks as much happiness as he can get — whether by helping others or winning in a game of poker. Not that economists worry too much about the satisfaction you or I might derive from caring for a sick child or helping a neighbor rake leaves. To be perfectly clear, what economists study is not man, but Homo economicus, whose sole aim is material wellbeing. Homo economicus, the story goes, does not act on impulse, but always rationally. He does not buy the first used car he sees, but calculates mileage, cost, safety, and features. As an investor, Homo economicus weighs the current price of a stock against the company’s intrinsic value. If the company is undervalued, he buys; if it is overvalued, he sells.
It is a neat little narrative, but quite obviously misleading. There is, for one thing, no room for the selfless acts of a Dorothy Day or Rosa Parks in the economist’s equations and diagrams. Nor did economists foresee the financial crisis of 2008 — resulting as it did from the manifestly irrational behavior of subprime mortgage buyers and sellers, SEC regulators, and investors.
Why, then, has The Myth of the Rational Market persisted for so long? The answer, I think, is in Justin Fox’s recent book. There are, in fact, many answers to many questions in Fox’s book, recounting as it does the long and convoluted history of the efficient market hypothesis, from its earliest incarnation in 1906 to its glory days at the University of Chicago in the 1960s, and subsequent decline. The Myth of the Rational Market is encyclopedic in its range, and Homeric in its cast of characters. But the place to begin answering the obvious question — how do we account for the dogged persistence of such a seemingly stupid idea? — is, I think, with Thomas Kuhn.
Kuhn’s name pops just a few times in the book; yet he is always there in the background, making sense of the madness. Kuhn’s big idea was the paradigm shift — the idea that true science was, as Fox puts it, “a field of study in which the practitioners took a number of fundamental assumptions as given and spent their days solving tiny puzzles in ways consistent with those assumptions. Often the assumptions eventually turned out to be wrong, but all that puzzle solving was still useful.” Which isn’t to say that economists are indifferent to truth, but that (to quote Kuhn) normal science is “predicated on the assumption that the scientific community knows what the world is like,” and that (to quote Fox) it is “only when hard-to-explain anomalies start cropping up within the paradigm of a science” that change is possible.
To suggest that the efficient markets hypothesis succeeded because of its utility is potentially misleading. The efficient markets hypothesis did not provide investors with a means of beating the market. It claimed just the opposite: if stock prices reflect all available information, no investor could possibly outwit the market. (Fred Macaulay famously made this point at a statistician’s dinner in April 1925 by flipping a coin several thousand times and comparing the results with the corresponding increases and decreases of a stock chart, which had nearly identical results.)
The question as to why the efficient markets hypothesis caught on among economists when it did is an interesting but vexing one. Surely it had something to do with the rise of financial markets and growing prestige of science. Wisely, Fox avoids generalization, steering us instead to the crossroads of individual motivation and scientific paradigm — which, in The Myth of the Rational Market begins with the reforming zeal of Irving Fisher. Fisher, Fox tells us, was a “leading prohibitionist, coauthor of a bestselling hygiene textbook, a disciple of the corn-flakes-prescribing Dr. Kellogg of Battle Creek, an early backer of the League of Nations, and a prominent advocate of eugenics.” As with his other endeavors, Fisher hoped economics, understood scientifically, would improve society. Fisher’s early efforts yielded what was later dubbed the “random walk hypothesis” (the precursor to efficient markets), albeit with the following caveat:
Were it true that each individual speculator made up his mind independently of every other as to the future course of events, the errors of some would probably be offset by those others. But, as a matter of fact, the mistakes of the common herd are usually in the same direction. Like sheep, they all follow a single leader.
Insofar as individuals do not always act rationally, stocks and bonds do not always move randomly, as the “random walk” supposed. Fisher wanted to get investors to act more rationally by teaching them economics and probability theory, not state that they were, in fact, always rational.
In subsequent years, Fisher’s notion that stock and bond prices moved randomly grew in momentum. In 1932, Holbrook Working proposed that the “apparent imperfection of professional forecasting . . . may be evidence of perfection of the market.” This is, according to Fox, the earliest statement in economics of the efficient market hypothesis. At the same time, Working’s empirical bent led him to resist developing the theory further. Nearly two decades later, Paul Samuelson reiterated Working, but with even stronger reservations:
One should not read too much into the established theorem. It does not prove that actual competitive markets work well. It does not say that speculation is a good thing or that randomness of price changes would be a good thing. It does not prove that anyone who makes money in speculation is ipso facto deserving of the gain or even that he has accomplished something good for society or for anyone but himself. All or none of these may be true, but that would require a different investigation.
The efficient markets hypothesis had not yet become a paradigm, in Kuhn’s sense of the word.
Along came Milton Friedman in the 50s to change all of that. After Friedman, economists would take for granted that stock and bond prices reflected all available information, and that the market was therefore perfect. No longer would economists fret about theory’s descriptive inaccuracy. “The relevant question to ask about the ‘assumptions’ of a theory,” Friedman (as quoted by Fox) wrote in a famous 1953 to an critic of economic orthodoxy,
is not whether they are descriptively ‘realistic,’ for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
With Friedman, in other words, economics became a scientific paradigm. At the same time, the efficient markets hypothesis was, it seems, useful to Friedman in a manner that his 1953 remark did not fully acknowledge: useful as a means of advancing libertarian ideas.
The efficient market hypothesis did not come into being as a scientific paradigm apart from the lived experience of its makers. Friedman, along with several other University of Chicago friends, worked for a time in New Deal Washington, where Fox says he “became disillusioned with government attempts to manage the economy.” One of Friedman’s key influences, Friedrich Hayek (famous for his book The Road to Serfdom) gravitated toward libertarianism as the result of dissatisfaction with government. As Fox explains, “having experienced the socialist ‘Red Vienna’ of the 1920s and watched the Nazi takeover of his homeland from afar, Hayek was appalled by the equanimity, even enthusiasm, with which Keynes and other English liberal intellectuals greeted the growth of government.” In 1947, Hayek gathered Friedman and several others at the Mont Pelerin Hotel in Switzerland, where the group solidified its libertarian philosophy, marking the beginning of what Friedman later described as the beginning of his “active involvement with the political process.” (It is no wonder that Friedman’s students and readers would come to think that markets really are perfect.)
Fox’s narrative continues with a discussion of further articulations of the efficient markets hypothesis by Eugene Fama, Steve Ross, Michael Jensen, and others. Fox recounts the rise of modern finance, beginning with the doctoral dissertation of Harry Markowitz on the riskiness of a stock portfolio; he explains us how derivatives and option-pricing and any number of arcane financial instruments came into being; he tells us about finance profs who became investors, and investors who adopted principles of finance. Suffice it to say, the efficient markets hypothesis became the standard working assumption, not just for economists, but nearly everyone involved with the stock market — for whom the idea became increasingly useful.
However much it hardened into dogma, the efficient markets hypothesis remained susceptible to criticism. There was, for one thing, the common sense critique. One of the book’s zestier anecdotes is a dinner party exchange in which psychologist Amos Tversky quizzes finance professor Michael Jensen:
Tversky asked Jensen to describe how his wife made decisions. Jensen regaled him with tales of her irrational behavior. Tversky asked Jensen what he thought of President Jimmy Carter. An idiot, Jensen said. And what about the policies of the Federal Reserve chairman? All wrong. Tversky continued listing decision makers of various sorts, all of whom Jensen found wanting. “Let me see if I’ve got this straight,” Tversky finally said. “When we talk about individuals, especially policy makers, they all make major errors in their decisions. But in aggregate they all get it right?”
Sandford Grossman and Joseph Stiglitz wondered why any trading would occur at all in a world of perfectly rational investors, since “all investors would have access to the same information and thus come to the same conclusions.” A paper by Larry Summers famously began with this piece of common sense: “THERE ARE IDIOTS. Look around.” Others made more sophisticated arguments: that due to “power laws” stock market prices “stroll about calmly if drunkenly much of the time — but not all of the time”; that people tend to overreact to “unexpected news and events”; and that there are limits to arbitrage, since professional investors often avoid contrarian bets so as to avoid losing clients.
There was, in short, mounting evidence against the efficient markets hypothesis — but, of course, that didn’t matter, because the theory worked. Until it didn’t. On October 19, 1927 the Dow Jones fell 23 percent and the S&P 500 20 percent. Largely responsible for the crash was portfolio insurance, which was supposed to mitigate — not add — risk. Again, the culprit was a lack of common sense. Warren Buffett, as quoted by Fox, was stunned:
The less these companies are being valued at, says this approach, the more vigorously [stocks] should be sold . . . As a “logical” corollary, the approach commands the institutions to repurchase these companies – I’m not making this up [italics his] – once their prices have rebounded significantly.
Even more problematic was the sheer likelihood of the crash, which researchers at UC-Berkley determined to be 10 to the -160th power. It was, as Fox puts it, “something investors could expect to happen once every couple billion billion years.” Those are pretty long odds, and yet the idea lives on – shockingly, even well into our own Great Recession!
Fox is a consummate storyteller, nearly succeeding at bringing the dismal science to life. Particularly entertaining are the pseudo-Homeric bios with which Fox introduces each new character. Here, for example, is how Fox introduces Victor Niederhoffer: “A perennial national squash champion, Niederhoffer let his smelly sports clothes pile up in his study cubicle and walked around campus with a monkey names Lorie — after his faculty adviser James Lorie — on his shoulder.” Also in keeping with the sensibility of the ancients, Fox instructs as he entertains — making accessible to an ignoramus like me the central concepts underpinning contemporary economics. One is left hoping that behavioral economics — the rise of which Fox discusses in detail — will break down some of the disciplines tired orthodoxies.
Despite its many achievements, The Myth of the Rational Market left me cold. One cannot overcome escape the sense that the discipline of finance was concocted by and for guys looking to strike it rich on the stock market. (Nor is the anti-government bias of Chicago-school economics palatable.) Since I can remember, I have objected to the very notion of separating ownership and control — to a business model in which the pursuit of profits trumps all other concerns — at the very heart of modern Wall Street. Capitalism has failed us, and I can only hope that an entirely new cast of characters will arise to create a paradigm useful to the many rather than the few — a paradigm that resembles none of the 20th-century’s failed ideologies.