What is there to say about Alan Greenspan, who at 87 is out flogging his new book, "The Map and the Territory: Risk, Human Nature and the Future of Forecasting?" Greenspan is a lightning rod, and views of his book range across the spectrum, from Larry Summers, who likes it, to Paul Krugman and Brad DeLong, who don't. I guess we should feel better because at least Greenspan made the effort; a number of other economists of the free-market, efficient-market, rational-expectations camp have chosen to forge ahead as if 2008 was a minor perturbation. Greenspan actually appears shaken; and he seems to have launched himself on a voyage to find out where he went wrong. At least that's the sense from Gillian Tett's treatment of Greenspan and his book in this weekend's Financial Times.
Greenspan has been saying a number of things on his magical mystery tour. He's confessed to a loss of faith in efficient markets - despite Eugene Fame getting a Nobel - and in the kind of rational expectations model-building that shaped much of Federal Reserve forecasting through his tenure. He now thinks banks need a lot more capital, and he told Tett that they might even need to be broken up. (Beyond that, he says very little about bank regulation, ignoring the fact that the Fed itself long encouraged great size.) He now thinks leverage is very bad. But more fundamentally, he offers the earth-shattering conclusion that perhaps investors are not always rational, that Homo economicus is just another model-building exercise that may have its intellectual uses but that founders occasionally in the real world. In short, he adopts the behavioral belief in investor irrationality, particularly in panics, which becomes his default explanation for bubbles.
In fact, he once asked Tett, who trained as an anthropologist, who he should read in anthropology and sociology - social sciences a long way from the chilly rigors of "scientific" economics.
And that's where I begin to have a problem with all this. It's true, Greenspan may have simply been flattering Tett (and providing her with a lead). But for all his earnest exploration, this man, once the world's most powerful central banker, essentially offers up a view of the markets that Robert Shiller, another new Nobelist, articulated in the first edition of "Irrational Exuberance" (a term that Greenspan himself coined) about 15 years ago. People are slightly crazy and markets break down.
There's been a considerable amount of academic work since then on the subject of bubbles, which does come down to human nature. (Let me pause for self-promotion: I wrote a piece for Institutional Investor in July-August that looked at some of this work, both on the nature of bubbles and what to do with them once they burst.) Much of it does argue for at least a part of the market to act "irrationally," defined as at odds with some underlying market equilibrium. This is the by-now common mass delusion theory of bubbles, which is applied - sometimes foolishly - to everything from Dutch tulipmania in the 17th century to the Great Depression. A number of academics have created models that describe mechanisms that feature heterogenous beliefs about where the market is heading, the kind of difference of opinion that the Rational Expectations Hypothesis does not really allow. As a result, some of these views are defined as irrational. A quiet struggle then occurs between rational and irrational investors, with prices rising in a climate of overconfidence - and even "rational" investors play, thinking they can get out. Rational is thus associated with knowledge of some hidden knowledge of where the market is really going.
Others go further. They argue that asset prices have a tendency to swing, as they have throughout history, particularly given "rational" disagreements about the future. Given that the future is unknowable, most market players are rational, in that they really have no idea of an underlying equilibrium that may be changing all the time, and that their interests and goals differ, sometimes dramatically. Markets are not perfect; they tend to fluctuate in unpredictable ways, and investors (not to say regulators, policymakers and politicians) may get caught. But that doesn't mean that markets swing from rationality to irrationality.
In this reading, characterizations of rationality and irrationality take place as a sort of judgment of history. Historical market winners are thus rational; losers are irrational. The insanity becomes apparent only after the fact. Acting rationally by looking into the future is a lot harder, which explains why so many miss major bubbles, such as 2008.
The very use of the word "rational" in terms of the markets is contentious and continues to be anchored in fundamental views, like efficiency, rational expectations and equilibrium; rational is always relative to irrational, as good is to bad. DeLong recently raked some academics over the coals for arguing that participants in tulipmania were simply acting as rational investors in an efficient market. DeLong denies, in fact, that the tulip market was efficient, which would tend to make investors in it rank speculators, prone to delusion. "For a market to be efficient, there has to be agreement first of all on what the commodity being sold is and on what quoted prices mean before you can even begin to talk about market efficiency and rationality," write DeLong. "Rational traders do not buy financial securities just because the seller whispers to them, 'I know the contract says that this is a futures, but I happen to know that it is going to be transformed into a call option, so pay no attention to what the piece of paper says -- I'm really offering you a very good deal.'"
Greenspan offers a different view of irrational markets. He doesn't focus on the "irrationality" of investing into a bubble, but on the ensuing panic when the bubble bursts. He tells Tett: "Fear is a far more dominant force in human behavior than euphoria - I would never have expected that or given it a moment's thought before but it shows up in the data in many ways. Once you get that skewing in [statistics from panic] it creates the fat tail." Really? Does the panic simply appear - or was there a fat tail of probabilities, say on subprime mortgages, already created that drives the panic? Is Greenspan suggesting that rationality prevailed until the bubble burst, and then folks acted irrationally, out of fear? What would be rational behavior in the face of a collapse? For everyone to sit on their positions in the hope of keeping falling markets upright? Is the conflict between saving yourself and saving everyone really a matter of rationality when prices are plunging? The fact is, no one really knows what the next person owns or is thinking - it can't be fully known - so there's no truly rational path out of this particularly tangled woods.
What this does do is cleverly allow Greenspan to wriggle out of some of the blame. It was fear, delusion, irrationality not euphoria-driven-by-greed that caused the meltdown. It was less the buildup, than the aftermath. It wasn't the "animal spirits" of the real estate boom that ran amok, it was the panic that followed. What can a central banker do when faced with investors who are seized by fear, engaged in panic selling and driven "by animals spirits that defy maths." Answer: not much. Same old, same old.
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