The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
by Justin Fox
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Book Summary Information
Author: Justin FoxEdition: Hardcover
Audio: English (Unknown); English (Original Language); English (Published)
Published: 2009-06-09
ISBN: 0060598999
Number of pages: 400
Publisher: HarperBusiness
Product features:
- ISBN13: 9780060598990
- Condition: New
- Notes: BRAND NEW FROM PUBLISHER! 100% Satisfaction Guarantee. Tracking provided on most orders. Buy with Confidence! Millions of books sold!
Book Reviews of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
Book Review: A great tour of economics since the 1920s
Summary: 5 Stars
For better or for worse, the starting point for all discussions about capitalism and its failings is some sort of arbitrage principle. Let's look at the free-market argument against the possibility of racial discrimination in hiring, for instance. (I'm fairly certain I've read something like this in Posner.) Suppose you have a highly qualified black candidate who doesn't get hired, because his potential boss just doesn't like the color of his skin. The free-market response would be that someone else will swoop in and hire that person away -- may, in fact, hire him for less than an equally-qualified white candidate. Companies that are systematically racist in their hiring will be beaten by those that aren't.
There are two possible ways of interpreting the arbitrage principle in here. Either a) all companies will behave in a rational way, which would actually make racist hiring impossible, or b) some smart company will behave rationally, thereby beating its racist competitors. Inasmuch as we agree that racist hiring exists, we can rule out a). Besides, like any evolutionary-type argument, the claim isn't that all actors or all organisms act in a certain way, just that competitive pressure will eventually force a particular outcome.
In any case, even b) depends rather sensitively on the structure of the market. If there are infinitely many companies competing for customers, then even the tiniest inefficiency -- racism, say -- will be ruthlessly purged from the market. If there are only a few car manufacturers, on the other hand, then inefficiencies may last for a very long time.
You might be asking why I've even bothered to advance the infinitely-many-competitors alternative here. You might also be asking why I'm starting with an arbitrage principle rather than the rather more obvious fact there there exist racists in this world, and they don't act rationally. I think Paul Krugman hit on the answer in Development, Geography, and Economic Theory: putting the irrational elements of the human brain into a model turns out to be hard, at least if you're going to cross all your mathematical Ts and dot all your mathematical Is in the way that economists trust. Another way to put it is that the perfect-competition model fits together in a way that few rival theories have yet been able to match. The Myth of the Rational Market quotes Richard Thaler to the effect that it's the difference between being exactly wrong or being vaguely right: the alternative models know they're on to something, even if they haven't put all the pieces together yet.
I went into Myth thinking that it wouldn't understand the virtues of modeling -- that it would just be another hand-waving gesture against "those stupid economists." I have real problems with this anti-quantitative attitude. Modeling things mathematically has real virtues: speaking clearly, stating your assumptions as concisely as possible, and opening yourself up to the possibility of being proved wrong. More-orthodox economists are on to something when they suggest that behavioral economics is a collection of nice stories but nothing to build a theory on. By now it's clear to me that they're wrong about that, but their hearts are in the right place.
What's amazing about The Myth of the Rational Market is that it hits all these notes and many, many more. It explains what orthodox economists think, and why. It describes behavioral economics of the Thaler school. It describes behavioral finance of the sort that Andrei Shleifer, Larry Summers, and Brad DeLong are famous for. It describes Keynesian economics. It goes into the efficient-markets hypothesis at a decent depth. It follows Eugene Fama -- the father, if anyone can claim that title, of the EMH -- for a few decades, eventually catching him laughing at how much of a turn his own mind has taken. (Earlier, Justin Fox had found Fama praising the stock market after the 1987 crash: surely the market had just shown its genius, having collapsed quickly after it discovered new information. No one could identify what that new information might be, however. Free marketeers do often have a point that The Market Is Smarter Than You: just because an economist can't figure out why the market does something doesn't mean the economist is smarter than the market. However, it seems clear that the 1987 crash wasn't a shining hour for Efficient Market Hypothesis.)
In fact, The Myth of the Rational Market follows essentially all of the economics profession from Irving Fisher to the present, and ends ... at a draw, which is exactly where it should be. The orthodox economists are right that we need a good theoretical model of irrational behavior if we're going to do it right and if we're going to incorporate it into the successful body of rational-actor theory. The behavioral economists are right that there's too much anti-rational behavior to count it as mere diversions from "real" economics. Behavioral finance has contributed a lot to our understanding of the stock market: the concept of a noise trader, and how he interacts with a rational trader, is an important one. The fact that there are times (like now!) when arbitrageurs can't borrow as much money as they would need to capitalize on the market's irrationality, and that those times are precisely when they need money the most, is an unfortunately important one.
Fox even follows this historical evolution into places where I wouldn't have expected him to. He takes us to the Santa Fe Institute for a few paragraphs. Among other things, SFI tries to simulate, on a computer, many semi-rational economic actors buying and selling from one another, then watch the collective behavior of these simulated actors. For instance, do simulated imperfect humans ever cause a stock market to bubble and crash? Do arbitrage opportunities persist and, in fact, widen? This falls under the general heading of "microfoundations": deriving explanations for high-level phenomena out of the (partially) realistic behavior of low-level actors. If the high-level macrobehavior that fall out of the model look like the world we're used to, then that's a start. If the macrobehavior look right and the economic actors look like real, sometimes-irrational people, then we're on to something. My limited skim of the literature suggests that we're not there yet.
Whether we get the models right matters, as a glance as today's newspapers will tell you. Whether we assume that humans are perfectly rational actors feeds directly into how skeptically we view mortgage brokers: if mortgage buyers are rational, why bother protecting them from balloon mortgages? Why be concerned that they might let Enron zero out their 401(k)s? Humans need a bit of help here and there; rational actors don't.
All of this is in Fox's book, which is a page-turner intended for a wide audience. It covers a broad enough swath of the discipline that it has probably singlehandedly killed a dozen other, lesser books on a few dozen sub-areas of economics. I confess that I went into it expecting that it would be another opportunistic work, riding the coattails of behavioral economics or of the recent crash. It does neither; it will still be readable and informative and fun in a few decades. Highly recommended.
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Summary of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
Chronicling the rise and fall of the efficient market theory and the century-long making of the modern financial industry, Justin Fox's The Myth of the Rational Market is as much an intellectual whodunit as a cultural history of the perils and possibilities of risk. The book brings to life the people and ideas that forged modern finance and investing, from the formative days of Wall Street through the Great Depression and into the financial calamity of today. It's a tale that features professors who made and lost fortunes, battled fiercely over ideas, beat the house in blackjack, wrote bestselling books, and played major roles on the world stage. It's also a tale of Wall Street's evolution, the power of the market to generate wealth and wreak havoc, and free market capitalism's war with itself.
The efficient market hypothesis?long part of academic folklore but codified in the 1960s at the University of Chicago?has evolved into a powerful myth. It has been the maker and loser of fortunes, the driver of trillions of dollars, the inspiration for index funds and vast new derivatives markets, and the guidepost for thousands of careers. The theory holds that the market is always right, and that the decisions of millions of rational investors, all acting on information to outsmart one another, always provide the best judge of a stock's value. That myth is crumbling.
Celebrated journalist and columnist Fox introduces a new wave of economists and scholars who no longer teach that investors are rational or that the markets are always right. Many of them now agree with Yale professor Robert Shiller that the efficient markets theory “represents one of the most remarkable errors in the history of economic thought.” Today the theory has given way to counterintuitive hypotheses about human behavior, psychological models of decision making, and the irrationality of the markets. Investors overreact, underreact, and make irrational decisions based on imperfect data. In his landmark treatment of the history of the world's markets, Fox uncovers the new ideas that may come to drive the market in the century ahead.
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