Market mysticism

A year ago, while testifying before the United States Congress, Alan Greenspan, the former head of the Federal Reserve, admitted that the economic theory he followed all his life, which assumed that self-regulating financial markets would function faultlessly, was “profoundly flawed”. To the world’s astonishment, he also expressed his surprise that market participants’ self-interest was not sufficient to protect the financial system’s stability from the sort of irresponsible behaviour that led to the worst crisis since World War II.

This belief – that self-interest is the basis of self-regulation by markets – became a dominant principle of American economic policy in the last 30 years. Democrats like Bill Clinton subscribed to it no less ardently than Republicans like Ronald Reagan and the two George Bushes.

For 30 years, economists from the so-called neo-classical school have been building powerful pseudo-scientific foundations for this ideology. According to their theories, markets define values in an exact way, and therefore should not fluctuate significantly. The recent financial crisis – triggered by a severe correction in US housing prices – should not have happened at all.

But since it did happen, a question should be asked: are recurrent crises provoked by our ideologically motivated refusal to consider capitalism’s propensity for extremes, both in the social sphere (for example, deep inequalities) and in the functioning of financial markets?

In capitalist economies, individuals and businesses innovate by discovering new ways of using capital, and by creating new technologies. These innovations are by their very nature unforeseeable, as is the evolution of their social context. They cannot be captured in any mechanical rule. Unpredictability is hard-wired into market economies.

But, whatever their flaws, financial markets and private property are the only social institutions known to us that are able, adequately though imperfectly, to consider diversity of knowledge and intuition in allocating capital. Incentives to innovate and to manage ever-imperfect knowledge are the main underpinnings of capitalism’s success. Conversely, the inability of the planned economies of eastern Europe and the Soviet Union to innovate was one of the main causes of their ultimate collapse – and of the complete disappearance of central planning as a serious economic alternative.

Paradoxically, however, contemporary economic theory has kept alive the core ideas of central planning, because it relies on a similarly false concept of rationality – one whose inadequacy was already proved by Friedrich Hayek. Central planning, Hayek concluded, is by its nature impossible, because no mathematical model can precisely mimic the behaviour of markets.

But mainstream contemporary economics understood Hayek’s conclusion about rationality as if it applied only to planned economies, while basing economic theory on a belief that economists can predict future market changes exactly. The creation and legitimation of today’s most controversial financial instruments rests on this false premise.

Financial models that assumed that it is possible to count precisely the causes of price fluctuations were widely used by America’s most respected financial institutions to price derivatives and financial insurance. Economic theory that treated these financial instruments as innovations – similar to the computer, for example – legitimized their use in markets worldwide. But these instruments correspond only slightly with prices and risk in financial markets, and their widespread adoption, we now know, fuelled market fluctuations and provoked the recent crisis.

What is worse, the false concept of rationality on which mainstream economic theory is based, also underpins mistaken conclusions about the proper extent of market regulation. As a result, contemporary economic models produce two extreme positions: exclusion of any active role for the state or radical state interventionism.

As Michel Foucault convincingly showed, language is power. Aware of this, the neo-classical economists carried out a real coup d’état. They created a para-scientific jargon that helped them to direct social choices in a very dangerous and unproductive direction. The premises that form the basis of their models became in great part inscrutable to anyone lacking a PhD in economics, and debate was infused with terms that mean one thing to the uninitiated and quite another to economists.

The concept of rationality forms the foundation of this discourse. In everyday language, rationality means common sense or reasonableness. By contrast, for economists, a “rational individual” is not merely reasonable; he or she is someone who behaves in accord with a mathematical model of individual decision-making that economists have agreed to call “rational”. The centrepiece of this standard of rationality, the so-called “Rational Expectations Hypothesis” (REH), presumes that economists can exactly model how rational individuals comprehend the future. The unreasonableness of this standard helps explain why macroeconomists and finance theorists find it so hard to account for large swings in market outcomes.

Indeed, economists’ incoherent premises have led them to embrace absurd conclusions – for example, that unfettered financial markets set asset prices nearly perfectly at their “true” fundamental value. If so, the state should drastically curtail its supervision of the financial system. Unfortunately, many officials worldwide came to believe this claim, known as the “efficient markets hypothesis,” resulting in the massive deregulation of the late 1990s and early 2000s that made the crisis more likely, if not inevitable.

In recent years, another school of thought, behavioural economics, has uncovered mountains of evidence that market participants do not act as conventional economists would predict “rational individuals” to behave. But, instead of jettisoning the bogus standard of rationality underlying those predictions, they interpret their empirical findings to mean that many market participants are irrational, prone to emotion, or ignore economic fundamentals for other reasons.

The behavioural view suggests that large swings in asset prices serve no useful social function. If the state could somehow eliminate them through massive intervention, or ban irrational players by imposing strict regulatory measures, the “rational” players could reassert their control and markets would return to their normal state of setting prices at their “true” values.

This is implausible, because an exact model of rational decision-making is beyond the capacity of economists – or anyone else – to formulate. Once economists recognize that they cannot explain exactly how reasonable individuals make decisions and how market outcomes unfold over time, we will no longer be stuck with two polar extremes concerning the relative roles of the market and the state.

An alternative theory of markets is needed, and its basis should be the fact that participants must cope with ever-imperfect knowledge about the fundamentals of economic change. This obvious feature of capitalism is completely ignored by the dominant market models, though it is the main explanation for asset-price fluctuations in market-based economies.

Such an alternative approach also leads to a new way of thinking about the respective roles of the state and financial markets. So long as price fluctuations remain within reasonable bounds, the state should limit its involvement to ensuring transparency, curbing monopolistic behaviour, and eliminating market failures. But when price fluctuations become excessive, as they did in the run-up to the recent crisis, the state can implement measures to limit their amplitude (though it always has a greater problem coping with imperfect knowledge than the market does).

A combination of passive and active roles for the state along these lines would leave markets to allocate capital while holding out the possibility of reducing the social costs that arise when asset-price swings continue for too long and then end, as they inevitably do, in sharp reversals.

Roman Frydman and Michael Goldberg’s book, Beyond Mechanical Markets was published in Spring 2011 by Princeton University Press.