A little ad hoc thinking from the University of Chicago (photo: quinn.anya)
There are many stupid things you have to believe if you want to be taken seriously on financial matters. One of them is called rational expectations theory. It and the efficient market hypothesis are two of the Chicago School’s economic theories that share the blame for the Great Crash of 2008. Both ideas depend on the quality of the information available to market players, and both fail when that information is rotten.
In his book, A Failure of Capitalism, and in an interview with John Cassidy in the January 11, 2010 New Yorker*, Judge Richard Posner soundly thwacks the true believers of the Chicago School. This is remarkable: Posner himself was a professor at the University of Chicago Law School, and is one of the founders of the law and economics movement, which he now espouses from the bench of the Seventh Circuit. Cassidy writes:
During our conversation, Posner questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis, which says that the prices of stocks and other financial assets accurately reflect all the available information about economic fundamentals, and the rational-expectations theory, which posits that individuals and firms are hyper-intelligent decision-makers who have a correct model of the economy in their heads.
The rational expectations theory is described in more detail in Wikipedia:
Rational expectations is a theory in economics that the sum of all decisions of all individuals and organizations, filtered through an endogenous set of market institutions, is not systematically wrong.
The rational expectations theory and the efficient market hypothesis form the academic basis for the Iowa Electronic Market, which allows people to bet on future events, such as the outcomes of elections or the US unemployment rate. Some players know something about each of these events, but no one knows the right answer. The idea is that if there are enough players and among them they have full information, they are likely to get the right outcome.
To be useful, rational expectations and the efficient market hypothesis both require that players take into account all relevant information. I don’t doubt that there are markets where all relevant information is available to all players. And I don’t doubt that in the market for a specific stock, almost all of the relevant information is available to a lot of players.
The problem is that in many financial markets there is a lot of information that isn’t available to all players. Furthermore, there are risks outside the markets that influence outcomes about which information isn’t available or likely to be accurate. It is obvious that even good decisions based on inadequate or false information will have bad outcomes. The following discussion is based on a paper written by Tom Van Dyck of the University of Leuven.**
1. Large finance companies are interconnected in unpredictable ways. That means that unpredicted instability of one institution can cause problems for others. AIG is the obvious example. It was impossible to know which institutions would be seriously damaged if AIG couldn’t pay out on its credit default swaps.
2. Apart from problems faced by one entity, there is the risk of financial panic, which could cause runs even on solvent finance companies.
3. Lending among finance companies is dependent on trust. If they cannot be reasonably confident in the financial position of another company, they won’t lend.
4. Each finance company has its own risk management program. No company has any way to know whether the risk management program is effective, or whether it is being followed, and based on their own experience, each is likely to mis-estimate the effectiveness of the program of all others.
Each of these risks was a cause of or an aggravating factor in the Great Crash. It is inconceivable that this information was used to set the prices of those derivatives that depend on the ability of the counterparty to perform. Instead, these apparently external possibilities were assumed away by each player under the rubric of the rational expectations theory and the efficient market hypothesis.
Judge Posner is apparently angry that economists were so willing to adopt what Cassidy calls “patently unrealistic theories”. Just as the Laffer Curve is used to justify tax cuts for the rich, these ideas were used to eliminate regulation of finance companies. And the results were just as predictably awful.
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* The article is only available to subscribers, and not easily even for them, but you can very likely access the story on-line through your Public Library; the article is well worth the trouble.
** This is a working paper and the author asks that people not quote it without his consent, which I do not have. I use some of his ideas in a different sequence.
