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    Joann M. Weiner

    Contributor

    Economists: Not As Smart as You Think (Or Are They?)

    Posted:
    09/6/09
    Filed Under:Economy, Woman Up
    16 Comments  + 
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    Economics appears to have replaced the law as the profession of ridicule. In April, for example, Business Week ran a cover story asking, "What Good Are Economists Anyway?" given that they failed to predict the worst recession since the Great Depression. More recently, Paul Krugman, writing for the New York Times, asks "How Did Economists get it So Wrong?"

    Krugman's "it" presumably refers to predicting the financial crisis. With his Nobel Prize in economics, Krugman's criticism of his profession is not likely to be ignored, and it shouldn't be. In his lengthy article for the Times, Krugman argues that "the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for the truth." Krugman identifies two tenets as the central cause of this failure: an idealized view that markets are perfect and that individuals are rational.
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    On the first point, Krugman asserts that the efficient market hypothesis, which says the price of a financial asset reflects all generally available relevant information at any time, is wrong. Second, he points out that investors often act irrationally and this irrationality can lead to speculative bubbles that the prevailing economic models fail to capture. Models built on the assumption that markets work perfectly and investors always act rationally will inevitably make catastrophic mistakes because they do not reflect economic reality. As Krugman says, "the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history."
    Krugman is not alone in his views. Twenty years ago, just after the October 1987 market crash, Lawrence Summers, who now heads the National Economic Council, told The Wall Street Journal that "the efficient market hypothesis is the most remarkable error in the history of economic theory."
    Are Krugman and Summers right? Is the efficient market hypothesis wrong? Did economists -- and everyone else -- rely on a faulty theory, and in so doing, watch helplessly as financial markets crashed a year ago?
    The answers to these questions are important not only for economists but also for the entire financial profession. The efficient market hypothesis is not some crackpot theory. It has a solid academic pedigree, with Nobel Prize-winning economists behind its development.
    Thus, if Krugman is right, then a generation of economists and business students may have to go back to the drawing board and develop a theory that can take into account the fact that sharp movements in stock prices that statistically should happen only once every 7,000 years seem to occur every three to four years. In particular, economists might consider developing models that incorporate the possibilities that asset price bubbles, whether in the stock market or in the housing market, regularly occur. It would also be extremely useful for economists to develop models that incorporate behavioral economics and take into consideration that investors may exhibit an irrational exuberance when markets are rising and an irrational risk aversion when markets are falling.

    Monkeys, Darts, and Stock Prices

    Thirty years ago, the economics profession adopted the theory, developed by Burton G. Malkiel, author of "A Random Walk Down Wall Street," that stock prices follow a random walk. This influential volume succinctly explained why it was impossible for an investor to consistently beat the market. As Malkiel explained, today's price reflects all information now known. Future prices will reflect only new information, which, by definition, is unknown. Thus, future prices must be unpredictable and, therefore, random. In the popular press, the theory became known as one where monkeys throwing darts could do as well as stock market analysts in predicting the path of stock prices.
    But, it is important to recognize that saying prices follow a random walk does not mean stocks never follow a pattern. Stock prices can and do follow trends. Take a look at the Dow Jones Industrial Average for 1999 and there is an unmistakable upward trend in prices. Making money in a rising market was easy. Of course, the technology bubble burst in 2000 and prices plummeted. How many investors, however, sold everything the day before?
    There are ways to make a sure profit in the market. Oliver Stone so famously described one in his 1987 classic, "Wall Street." In that film, stockbroker Bud Fox gives corporate raider Gordon Gekko insider information about the Bluestar company. When Gekko then makes a killing on the stock, he confirms his suspicions that Fox does not have any magical powers -- he simply had access to insider information about Bluestar's upcoming good financial news.
    How does this movie relate to the efficient market hypothesis? Recall that the hypothesis assumes that the price reflects all available information; that is, investors are on a level playing field. But as Gordon Gekko showed, markets cannot be efficient if prices do not reflect all information or if some investors have access to information that other investors do not. This insight holds in today's markets, where there are clear cases where some investors have information before other investors.
    Consider, for example, the practice of flash trading where some specialists obtain information several milliseconds before the market receives the information. Flash traders have the opportunity to do in milliseconds what Gordon Gekko did overnight 22 years ago. (Flash trading is not illegal, although SEC Chairwoman Mary Schapiro is sufficiently concerned about the inequities of this practice to consider banning flash orders.)
    Another example: As The Wall Street Journal reported in August, for the past couple of years Goldman Sachs has been giving members of its "trading huddle" stock tips several days before releasing its research reports to its other clients. This select group of investors had access to information that other investors were denied. Goldman defends this practice as a way to cater to the goals of short-term investors over long-term investors. Assuming these investors buy or sell stocks based on this privileged information, it is very easy to understand why today's stock price might not reflect all relevant information.
    That said, not all economists condemn the efficient market hypothesis. Nobel Prize winner Robert Lucas defended the hypothesis in a recent Economist article where he acknowledged that no model is able to predict all future events. As he noted, "what we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September."

    The Market: Rational, Irrational or Both?

    In light of the evidence that markets are not always efficient, how do we evaluate Krugman's other main point that investors often act irrationally rather than rationally, and therefore models that assume rational behavior are flawed? If investors were rational, as Krugman recalls, the market would not have dropped 23 percent in a single day, as it did in October 1987, for no clear reason.
    This sharp market fall and the more dramatic collapse in 2008, however, do not show that investors regularly act irrationally or that the models are flawed. As Lucas pointed out, no model could predict the sudden collapse of Lehman Brothers and the resulting financial distress that occurred. Even economist Robert C. Merton noted in his Nobel Prize address that "The mathematics of financial models can be applied precisely, but the models are not at all precise in their application to the complex real world." The decline in the stock market over the past year illustrates this proposition. Investors generally act rationally – except when they don't.
    To understand why markets can be both rational and irrational, it helps to look beyond traditional economic models. Perhaps Dan Ariely has the answer. He notes in his book, "Predictably Irrational," that there may be hidden forces that shape our decisions. As he explains, people can be very irrational when what they really care about is how they are doing relative to how others are doing. In other words, we really want to "keep up with the Joneses," so we make decisions that may be irrational.
    The housing market shows that individuals can act irrationally and that this irrationality is predictable. For example, subprime borrowers didn't know they could purchase a home with no money down and no interest due for years until they saw the McMansion their neighbors were building under those terms. And, to make matters worse, once the neighbors used their home equity to put in a backyard pool, home theater, and steam shower, the potential buyer also wanted a pool, theater, and steam shower.
    By contrast, the typical contestant on "Who Wants to be a Millionaire?" acts very rationally. The vast majority of contestants decide to walk away with their winnings well before reaching the million-dollar question. Why? Even though the contestant arrived with nothing, he or she would rather leave with, say, a certain $32,000 than take the chance of leaving in the same position in which they arrived. This behavior is not irrational.
    Figuring out when markets are efficient and when they are not and when people act rationally and when they do not is critical to figuring out why economists failed to predict the financial crisis.
    First of all, the analysis shows that markets may not always reflect all available information considering the proliferation of flash trading, off-balance sheet assets, structured investment vehicles, and preferential trading circles. The consequence of this "failure" is that investors with privileged information will win and those without this privilege will lose. More importantly, it calls for the end of practices that deem some investors worthy of advance information and others not.
    Second, the fact that investors often adopt a herd mentality says that they may act in a predictably irrational way. If housing prices rise as they always have, then it makes sense to expect that prices will continue to rise, at least for a while. Investors can ignore the consequences of a highly improbable outcome occurring since it is so unlikely that it will occur.
    Yet, ignoring that highly improbable outcomes may occur led Krugman to ask "How Did Economists Get it So Wrong?" Why didn't economists take into account the possibility -- as remote as it could be -- that the housing crisis could spread into a global financial crisis so quickly?
    Those are good questions and ones that the economics profession will be debating heavily in the years to come. Yet, to conclude that economists are dumb because their models did not predict the crisis would be wrong. Economists are not as dumb as you may think.
    In defense of the efficient markets hypothesis and economists, of which I am one (I studied for my Ph.D. at Harvard in the 1980s), the hypothesis makes a lot of sense if all information is available to everyone at the same time. It is also rational to not put much weight on outcomes that only very rarely occur. After all, why plan for the levies failing in New Orleans when there has never been a hurricane as strong as Katrina was in 2005 that broke the levies, flooded the city, and caused an immeasurable amount of human suffering?
    Krugman implies that the economic theory is flawed because it fails to fully account for irrational behavior and imperfect markets.
    But, perhaps things are not as bad as Krugman suggests. Even if a model did make such a prediction, would economists be courageous enough to take action to prevent the catastrophe? Would the Fed have cut interest rates to zero before the crisis hit? The government had the possibility of converting Lehman Brothers into a bank holding company months before it went bankrupt, but didn't do so. It is difficult for humans to respond today to an event that has not yet occurred, and it is even more difficult to respond if that response is painful (even though, in hindsight, it becomes clear that the damage caused by preventative action is less costly than the clean-up.) For markets to function, we have to act as if highly improbable outcomes rarely occur. If we have to react today to every possible outcome, no matter how remote, then it will be very hard to get anything done. As Lucas said, it makes no sense to drive your car into a ditch now to avoid a head-on crash because the car coming around the curve might be in your lane.
    Yet, the economic collapse shows that we cannot ignore the fact that extreme events do occur. When a very rare "black swan," to use Nassim Taleb's term, appears, how should we react? How should the Obama administration deal with the fact that catastrophic collapses can, and do, happen? Should the markets be prevented from taking extreme risks? As all business school students learn, greater returns come only after taking greater risks (although, many B-school graduates recently acted as if this proposition no longer held). Thus, curbing risk-taking will also curb extreme returns. Would we really be better off if we all were satisfied with being average? I'm not so sure.
    You might also feel this same way if you consider Tennyson, who said "Tis better to have loved and lost, than never to have loved at all."
    This financial crisis and economic recession are imposing nearly unbearable pain on the global economy, and that pain should not be treated cavalierly. Yet, as irrational as it may seem, it may be better to have had the opportunity to reach extreme heights, and experience the benefits of reaching the top, even if it means that sometimes we fail and fall to immeasurable depths.


    Joann M. Weiner holds a Ph.D. in economics and is an adjunct professor at The George Washington University, where she teaches public economics and a seminar on the causes and consequences of the financial crisis. She previously worked for the U.S. Treasury Department and for the European Commission while living in Brussels.







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    Joann M. Weiner

    Joann Martens Weiner is a lecturer at George Washington University, where she teaches public economics... more

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