Crisis Delivers Black-Eye to Classic Economists

September 9, 2010 at 12:23 am 8 comments

Markets are efficient. Individuals behave rationally. All information is reflected in prices. Huh…are you kidding me? These are the beliefs held by traditional free market economists (“rationalists”) like Eugene Fama (Economist at the University of Chicago and a.k.a. the “Father of the Efficient Market Hypothesis”). Striking blows to the rationalists are being thrown by “behavioralists” like Richard Thaler (Professor of Behavioral Science and Economics at the University of Chicago), who believes emotions often lead to suboptimal decisions and also thinks efficient market economics is a bunch of hogwash.

Individual investors, pensions, endowments, institutional investors, governments, are still sifting through the rubble in the aftermath of the 2008-2009 financial crisis. Experts and non-experts are still attempting to figure out how this mass destruction occurred and how it can be prevented in the future. Economists, as always, are happy to throw in their two cents. Right now traditional free market economists like Fama have received a black eye and are on the defensive – forced to explain to the behavioral finance economists (Thaler et. al.) how efficient markets could lead to such a disastrous outcome.

Religion and Economics

Like religious debates, economic rhetoric can get heated too. Religion can be divided up in into various categories (e.g., Christianity, Islam, Judaism, Hinduism, Buddhism, and other), or more simply religion can be divided into those who believe in a god (theism) and those who do not (atheism). There are multiple economic categorizations or schools as well (e.g., Keynsians, monetarism, libertarian, behavioral finance, etc.).  Debates and disagreements across the rainbow of religions and economic schools have been going on for centuries, and the completion of the 2008-09 financial crisis has further ignited the battle between the “behavioralists” (behavioral finance economists) and the “rationalists” (traditional free market economists).

Behavioral Finance on the Offensive

In the efficient market world of the “rationalists,” market prices reflect all available information and cannot be wrong at any moment in time. Effectively, individuals are considered human calculators that optimize everything from interest rates and costs to benefits and inflation expectations in every decision. What classic economics does not include is emotions or behavioral flaws.

Purporting that financial market decisions are not impacted by emotions becomes more difficult to defend if you consider the countless irrational anomalies considered throughout history. Consider the following:

  • Tulip Mania: Bubbles are nothing new – they have persisted for hundreds of years. Let’s reflect on the tulip bulb mania of the 1600s. For starters, I’m not sure how classic economists can explain the irrational exchanging of homes or a thousand pounds of cheese for a tulip bulb? Or how peak prices of $60,000+ in inflation-adjusted dollars were paid for a bulb at the time (C-Cynical)? These are tough questions to answer for the rationalists.
  • Flash Crash: Seeing multiple stocks (i.e., ACN and EXC) and Exchange Traded Funds (ETFs) temporarily trade down -99% in minutes is not exactly efficient. Stalwarts like Procter & Gamble also collapsed -37%, only to rebound minutes later near pre-collapse levels. All this volatility doesn’t exactly ooze with efficiency (see Making Millions in Minutes).
  • Negative T-Bill Rates: For certain periods of 2008 and 2009, investors earned negative yields on Treasury Bills. In essence, investors were paying the government to hold their money. Hmmm?
  • Technology and Real Estate Bubbles: Both of these asset classes were considered “can’t lose” investments in the late 1990s and mid-2000s, respectively. Many tech stocks were trading at unfathomable values (more than 100 x’s annual profits) and homebuyers were inflating real estate prices because little to no money was required for the purchases.
  • ’87 Crash: October 19, 1987 became infamously known as “Black Monday” since the Dow Jones Industrial Average plunged over -22% in one day (-508 points), the largest one-day percentage decline ever.

The list has the potential of going on forever, and the recent 2008-09 financial crisis only makes rationalists’ jobs tougher in refuting all this irrational behavior. Maybe the rationalists can use the same efficient market framework to help explain to my wife why I ate a whole box of Twinkies in one sitting?

Rationalist Rebuttal

The rationalists may have gotten a black eye, but they are not going down without a fight. Here are some quotes from Fama and fellow Chicago rationalist pals:

On the Crash-Related Attacks from Behavioralists: Behavioralists say traditional economics has failed in explaining the irrational decisions and actions leading up to the 2008-09 crash. Fama states, “I don’t see this as a failure of economics, but we need a whipping boy, and economists have always, kind of, been whipping boys, so they’re used to it. It’s fine.”

Rationalist Explanation of Behavioral Finance: Fama doesn’t deny the existence of irrational behavior, but rather believes rational and irrational behaviors can coexist. “Efficient markets can exist side by side with irrational behavior, as long as you have enough rational people to keep prices in line,” notes Fama. John Cochrane treats behavioral finance as a pseudo-science by replying, “The observation that people feel emotions means nothing. And if you’re going to just say markets went up because there was a wave of emotion, you’ve got nothing. That doesn’t tell us what circumstances are likely to make markets go up or down. That would not be a scientific theory.”

Description of Panics: “Panic” is not a term included in the dictionary of traditional economists. Fama retorts, “You can give it the charged word ‘panic,’ if you’d like, but in my view it’s just a change in tastes.” Calling these anomalous historic collapses a “change in tastes” is like calling Simon Cowell, formerly a judge on American Idol, “diplomatic.” More likely what’s really happening is these severe panics are driving investors’ changes in preferences.

Throwing in White Towel Regarding Crash: Not all classic economists are completely digging in their heels like Fama and Cochrane. Gary Becker, a rationalist disciple, acknowledges “Economists as a whole didn’t see it coming. So that’s a black mark on economics, and it’s not a very good mark for markets.”

Settling Dispute with Lab Rats

The boxing match continues, and the way the behavioralists would like to settle the score is through laboratory tests. In the documentary Mind Over Money, numerous laboratory experiments are run using human subjects to tease out emotional behaviors. Here are a few examples used by behavioralists to bolster their arguments:

  • The $20 Bill Auction: Zach Burns, a professor at the University of Chicago, conducted an auction among his students for a $20 bill. Under the rules of the game, as expected, the highest bidder wins the $20 bill, but as an added wrinkle, Burns added the stipulation that the second highest bidder receives nothing but must still pay the amount of the losing bid. Traditional economists would conclude nobody would bid higher than $20. See the not-so rational auction results here at minute 1:45.

  • $100 Today or $102 Tomorrow? This was the question posed to a group of shoppers in Chicago, but under two different scenarios. Under the first scenario, the individuals were asked whether they would prefer receiving $100 in a year from now (day 366) or $102 in a year and one additional day (day 367)? Under the second scenario, the individuals were asked whether they would prefer receiving $100 today or $102 tomorrow? The rational response to both scenarios would be to select $102 under both scenarios. See how the participants responded to the questions here at minute 4:30.

Rationalist John Cochrane is not fully convinced. “These experiments are very interesting, and I find them interesting, too. The next question is, to what extent does what we find in the lab translate into how people…understanding how people behave in the real world…and then make that transition to, ‘Does this explain market-wide phenomenon?,’” he asks.

As alluded to earlier, religion, politics, and economics will never fall under one universal consensus view. The classic rationalist economists, like Eugene Fama, have in aggregate been on the defensive and taken a left-hook in the eye for failing to predict and cohesively explain the financial crash of 2008-09. On the other hand, Richard Thaler and his behavioral finance buds will continue on the offensive, consistently swinging at the classic economists over this key economic mind versus money dispute.

See Complete Mind Over Money Program

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in ACN, EXC, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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