Beyond The Myth of the Rational Market

Justin Fox's book, The Myth of the Rational Market has been reviewed widely and received, in the main, good notices. Indeed, it's a pleasant read through some pretty forbidding material, though by necessity there's quite a bit of overlap with the late Peter Bernstein's Against the Gods and Capital Ideas, which cover the origins and growth of the efficient market thesis. Fox's book is actually a slightly less technical version than what Bernstein offers, though one with a different spin. Bernstein embraced the power of these ideas and saw how they had fundamentally reshaped much of investing. Fox, looking at them through the prism of the financial crisis, is a lot less impressed and, particularly in the second half of the book, lays out the counterarguments.

So who's right? How should we characterize the market post-crisis? It's a striking fact that for all the talk of fundamentally remaking the system, the markets themselves have been pretty much left out of the plans. Instead, the emphasis has been on institutional behavior, individual incentives, governance, controls, regulatory restructuring -- in many cases, in bringing markets back. The notion that we should rein in the markets, say by rethinking the pension system, has been a nonstarter. Corporate governance, now more than ever, turns on shareholder and on shareholder performance. And even mark-to-market accounting has been tweaked only on the margins. The penetration and ubiquity of the markets on Main Street looks to be nearly as complete after the crisis as before.

In a sense, then, despite the denunciation of deregulation and the free-market ideology, we haven't left the market behind. It often feels as if it's all we've got. Even the existence of a considerably more omnipresent federal involvement seems certain to decline as the economy improves, though not if you listen to the right wing. There's a general consensus that market-based pricing and entrepreneurial activities produces a more "efficient" allocation of resources than bureaucratic decisions laced with politics. And, for all the talk of behavioral economics and all the discussion of the "myth" of rational markets, the financial world, from money management with its modern portfolio theory and corporations, with their capital asset pricing models, continues to function as if the market were both efficient and rational.

The market is what IBM Corp. (NYSE:IBM) used to be days of yore: the safest default option. The fact is the efficient or rational market is a lot like derivatives. There are clearly times when the market is "more rational" than others, just as there are times -- many times actually -- when derivative instruments flash their "good" side, notably their ability to diffuse risk and to hedge and times when the "bad" or speculative side, emerges. What is most clearly wrong here is the broad extension of the rational or efficient market into the realm of ideology. Markets, as the behavioral crowd has been telling us for a while, aren't always rational. They are not a mechanism that can be trusted at all times. They are not some Platonic mechanism that should factor into every public and private policy. They are not omniscient or uniformly prescient -- although it really didn't take the financial crisis to realize that. But the very fact, which can't be denied, that markets are difficult to beat consistently continues to be an impressive reality. Its significant that a leading behavioral economist, Yale's Robert Shiller, argues for a greater use of risk management, not less.

And if the rational markets are a true myth, what are we to do? What would replace them? Is anyone in their right mind ready to junk portfolio diversification in money management or CAPM as a tool for companies allocating capital resources? That's not to say we shouldn't revisit some fundamental notions such as our broad obsession with quantitative performance, our focus on short-term investing or our willingness to judge every action as a mark-to-market calculation. But we're hardly about to return to the mid-1960s, before there was a fully accepted intellectual superstructure built around the notion that markets are generally smart. Like a cliché, a myth may well have a core of validity. We should probably spend some more time thinking about where that line between rational and irrational falls.

Also see:
The continuing relevance of Peter Bernstein

Robert Teitelman is editor in chief of The Deal.

Follow Robert Teitelman on Twitter: www.twitter.com/@newsgirlmw

Comments

[Henry]

Robert,
There are some fundamentals you missed. What kind of market exists when the central bank sets interest rates at zero? I believe that what we have called the market was a "national" market where it was "deposits" (and not funny-money derivatives parading from such things as carry-trade) that funded loans and the amount of credit had some relation to savings! Remember that?
It's also true that speculation, financial speculation, to drive up commodity prices like oil, have nothing to do with traditional and historical 101 fundamentals. This was all greed based and was a pornography to what the proper purpose of market allocation signals would have delivered.
It's also true that the globalization of the dollar, the NYMX pricing of oil in alliance with OPEC cartel pricing pisses all over the fundamentals of the market. If you remember the fundamentals, no individual in the market place has enough strength to effect the price. Ha! What a crock that has turned out to be.
If funny-money, speculation, naked-shorting, mega-leverage are such fairy-tale components of the market place.... well, then maybe we've arrived. If you were to pay attention, you'd realize that Uncle Ben of the Fed has rates at zero for a reason. This reason has nothing to do with the free market. What sort of rate do you think the free market would have delivered?

[RoloTomassi]

More Wall St. driven self-congradulatory BS.

Someday free market fundamentalism will destroy this country...­.