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How Did Economists Blow It? Part 3 – The Assumed Markets Theory

Two week­ends ago Paul Krug­man explained in a New York Times Mag­a­zine arti­cle that many econ­o­mists can’t fore­cast the econ­omy because they have a cultish belief in the nearly always wrong effi­cient mar­ket the­ory.  Mr. Krugman’s solu­tion, an aca­d­e­mic exor­cism where econ­o­mists renounce their loy­alty to the effi­cient mar­ket the­ory and swear alle­giance to neo-Keynesianism, has cre­ated quite a stir in the pro­fes­sion and prompted a num­ber of per­sonal and pro­fes­sional attacks on Mr. Krug­man.  Unfor­tu­nately, both Mr. Krug­man and the effi­cient mar­kets believ­ers are both wrong.  The the­ory is cor­rect but the con­di­tions nec­es­sary for the effi­cient mar­kets the­ory to work don’t exist. 

Mr. Krug­man sug­gests that econ­o­mists missed the Great Reces­sion because they relied upon math­e­mat­i­cal mod­els that assume the econ­omy is a series of free and effi­cient mar­kets and there­fore a self cor­rect­ing pre­dictable eco­nomic organ­ism.  Mr. Krug­man pro­poses “econ­o­mists need to aban­don the neat but wrong solu­tion of assum­ing that every­one is ratio­nal and mar­kets work per­fectly”.  Instead, Mr. Krugman’s solu­tion is to sub­sti­tute Key­ne­sian mod­els for effi­cient mar­kets mod­els when he states that “Key­ne­sian eco­nom­ics remains the best frame­work we have for mak­ing sense of reces­sions and depres­sions”. 

Unfor­tu­nately, the usu­ally smart and intu­itive Mr. Krug­man for­got that for the effi­cient mar­ket the­ory to work its pri­mary assump­tion must be true; that the mar­kets are free, fair and open, and that is sim­ply not the case. 

Mr. Krug­man isn’t alone in assum­ing and fore­cast­ing based upon mar­kets that don’t exist, and then not under­stand­ing why fore­cast­ing don’t work.  Pretty much the entire eco­nom­ics pro­fes­sion plays a game of pre­tend when they write about mar­kets with­out check­ing the most basic real world under­ly­ing oper­a­tional and func­tional assump­tions. 

Econ­o­mists assume that the U.S. mar­kets are free, fair and open and there­fore a per­fect Petrie dish for test­ing free mar­ket the­o­ries.  But, instead of try­ing to fig­ure out if free, fair and open mar­kets exist, when their math­e­mat­i­cal mod­els don’t work many promi­nent econ­o­mists (includ­ing Mr. Krug­man) take the posi­tion that investors aren’t ratio­nal, soci­ety has a herd men­tal­ity and gen­er­ally we are all “idiots”.  These econ­o­mists pon­tif­i­cate with­out self doubt and pub­lish with­out reflec­tion. 

I dis­agree with the “our mod­els are wrong because peo­ple are idiots” crowd and think that, as a group, soci­ety is extra­or­di­nar­ily smart, log­i­cal and ratio­nal.  When we act in a herd it is because we are all get­ting stuck by the same cat­tle prod and being bit at by the same sheep­dog.  Instead of say­ing peo­ple are dumb and fric­tion exists in mar­kets, econ­o­mists should spend their time try­ing to under­stand the com­mon soci­o­log­i­cal, gov­ern­men­tal, psy­cho­log­i­cal and eco­nomic stim­uli that moti­vate each and every one of us. 

I can’t think of a sin­gle major “mar­ket” that always sat­is­fies the under­ly­ing assump­tions of the effi­cient mar­ket the­ory.  Even the New York Stock Exchange, per­haps the most free and open mar­ket in the world, some­times is a free, fair and open mar­ket and some­times isn’t.  Free, fair and open are mov­ing tar­gets that require con­stant vig­i­lance to make sure soci­etal drift doesn’t con­vert mar­kets into rigged exchanges.  When the large bro­ker­age houses are able to rip bil­lions of dol­lars of profit out of New York Stock Exchange trades by front run­ning their clients with really fast com­put­ers, the New York Stock Exchange fails to be free, fair and open.  When no one is really sure what the short sale rules are or how they work, and nei­ther does the SEC, the mar­ket stops being fair.  And, when some peo­ple have inside infor­ma­tion that they sell to their best clients, the New York Stock Exchange stops being the show­case for the effi­cient mar­ket the­ory and turns into a Mid­dle East­ern rug bazaar. 

But the prob­lems don’t stop with the NYSE.  Free mar­ket advo­cates argue that the credit deriv­a­tives mar­kets pro­vide asset price dis­cov­ery and increase effi­ciency but never test the under­ly­ing assump­tion of whether or not these mar­kets are real.  For exam­ple, it’s unclear if prices reported on credit default swaps (which are unreg­u­lated) are actu­ally accu­rate or made up and most insid­ers say that it is well known reported prices are often fake.  Even more uncer­tain is whether or not prices in the credit default swap mar­ket, if reported accu­rately, are being manip­u­lated by ad hoc car­tels that are exe­cut­ing coor­di­nated and coop­er­at­ing trad­ing strate­gies. 

Even LIBOR, the float­ing inter­est rate index that under­pins most cor­po­rate and per­sonal debt in the world, isn’t really a mar­ket rate.  It is an esti­mate of a mar­ket rate that is cal­cu­lated by an indus­try trade asso­ci­a­tion in secret, with­out over­sight and based upon inputs from a select group of indus­try sources.  The sup­pos­edly free and fair inter­bank mar­kets that last year were the focus of intense media and pub­lic pol­icy scrutiny don’t trade based upon actual pub­lished infor­ma­tion and are there­fore nei­ther fair nor open.  Once again, the require­ments for the effi­cient mar­ket the­ory to be valu­able in pre­dict­ing behav­ior haven’t been met. 

Free mar­ket the­o­ries require equal bar­gain­ing power among mar­ket par­tic­i­pants.  Who believes that con­sumers have equal bar­gain­ing power against banks, insur­ance com­pa­nies or util­i­ties?  Or, that con­sumers have real choice when they exe­cute the sim­plest finan­cial trans­ac­tions such as access­ing revolv­ing con­sumer credit?  The choice of “Mas­ter­Card” or “Visa” isn’t real choice or com­pe­ti­tion.  And, when was the last time any con­sumer was granted credit after opt­ing out of the credit bureau sys­tem?  Most con­sumer credit con­tracts are con­tracts of adhe­sion, i.e., con­sumers don’t have a real choice or bar­gain­ing power, and, as a result, the under­ly­ing assump­tions for effi­cient mar­kets don’t exist.

Econ­o­mists who fell in love with free mar­ket the­o­ries can’t stand the fact that rules are needed to make sure that mar­kets are free, fair and open.  After all, rules are typ­i­cally enforced by gov­ern­ments and are called reg­u­la­tions.  Gov­ern­ment reg­u­la­tion is the sworn blood enemy of true free mar­ket believ­ers.  Free mar­ket believ­ers for­got that reg­u­la­tion is sup­posed to pro­mote com­pe­ti­tion and instead got car­ried away and destroyed mar­ket reg­u­la­tion that that made sure that the play­ing field was level and fair. 

Vir­tu­ally all econ­o­mists would rather shift the blame for miss­ing the Great Reces­sion onto some­one else.  Free mar­ket econ­o­mists try to explain their mis­takes by say­ing that that mar­kets are irra­tional and it isn’t their fault for not being able to under­stand and pre­dict irra­tional and ran­dom behav­ior.  Some econ­o­mists, like Mr. Krug­man, shift the blame to other econ­o­mists for not real­iz­ing that while mar­ket the­o­ries have a place in eco­nom­ics, they are infe­rior to Mr. Krugman’s favorite Key­ne­sian framework.

But mostly econ­o­mists got it wrong because they didn’t watch old episodes of All In The Fam­ily.  If they sim­ply watched late night TV econ­o­mists wouldn’t have assumed any­thing about mar­kets because they would have known what Archie Bunker explained to Amer­ica more than 30 years ago:

When you assume you make and ass of you and me”.




Posted in: Credit Crisis, economy, New York Times, Paul Krugman, Public Policy, REGULATION

1 Comment

  1. Craig Ferguson

    Very inter­est­ing arti­cle. My take is that “free” inher­ently means respon­si­ble, not with­out limi­ti­a­tions. Free Mar­kets need to be respon­si­ble in order to lean towards fair­ness. While I am con­cerned that all too often gov­ern­ment reg­u­la­tion misses the mark in facil­i­tat­ing mar­ket respon­si­bil­ity, it is still needed, espe­cially in the deriv­a­tives mar­ket. I think exchange traded CDSs can help move towards responsibility.

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