This displays all the hallmarks of the behavioral program touted by Akerlof and Shiller. First, a reputedly irrational behavior (looting and destruction of banks by their owners) is rendered “rational” through the minor amendment of a simple orthodox maximization exercise by tinkering with the utility function of bank owners. Insights from professional psychology are absent. The prospect that such behavior would bring the capitalist system to its knees is simply ignored. Macroeconomic phenomena are reduced to isolated individual choices in a manner far less sophisticated than in the reductionist rational-expectations movement. Predictably, the model adds nothing to what simple intuition would suggest, given the problem has been artificially restricted to a rudimentary cost-benefit exercise beforehand. Indeed, the model does not particularly illuminate the situation that nominally inspired it, since it does not encompass any of the specific institutional detail pertinent to the phenomenon; that is, it bypasses consensus factors that precipitated the crisis at that particular juncture. It ignores the breakdown of Depression-era walls between depository and investment institutions, and neglects the spread of baroque securitization at the behest of finance economists. But more to the point, their supposedly left-liberal approach ends up backhandedly reproducing the conventional neoliberal story, as was pointed out by Gregory Mankiw in his published commentary:
Although the two authors from Berkeley did not intend this paper to be a defense of Ronald Reagan and his view of government, one can easily interpret it in this way. The paper shows that the savings and loan crisis was not the result of unregulated markets, but of overregulated ones . . . The policy that led to the savings and loan crisis is, according to these authors, deposit insurance.46
Paul Romer, the other author of this paper, revealed his own neoliberal leanings when questioned concerning the crisis in 2011. “Every decade or so, any system of financial regulation will lead to systemic financial crisis.”47 Note well that for Romer it was not private financial sector “corruption” that produced instability, but rather government snafus in regulation, the standard public-choice account. His grasp of economic history was not very profound, either.
Hence, when some economists speculated that the orthodoxy would give way to a “more realistic” behavioral economics in reaction to the crisis, it was primarily a symptom of the general unwillingness to entertain any serious departure from conventional arguments.48 If anyone had bothered to actually read any of the leaders of the behavioral “movement,” they would have quickly realized that those economists went out of their way to renounce any ambitions to displace the orthodoxy. In one spectacularly badly timed compromise, in 2005 Andrew Lo had sought to reconcile the findings of behavioral finance with the efficient-markets hypothesis. And most behavioral economists couldn’t care less about the layered complexity of the human soul.49 Indeed, one needn’t look far to encounter their contempt for the academic psychology profession:
I think we strive for parsimonious, rigorous theoretical explanations; this distinguishes us from the psychologists . . . Economists want a theory that provides a unifying explanation of these results whereas psychologists are much more willing to accept two different theories to explain these “contradictory” results . . . I don’t like the argument that everything is context dependent. That view lacks any grounding. In this regard, I really like the strong theoretical emphasis of economics and our desire for unifying explanations. It distinguishes us a lot from biologists and psychologists, and provides us with a normative anchor.50
If you asked behavioral economists what all this tinkering with conventional neoclassical utility functions was supposed to portend, they would tell you in no uncertain terms that so-called behavioral economics “is based not on a proposed paradigm shift in the basic approach of our field, but rather is a natural broadening of the field of economics . . . [it is] built on the premise that not only mainstream methods are great, but so too are mainstream economic assumptions.”51
So wherever did the vast bulk of lay commentators derive the unfounded impression that behavioral economics was poised to deliver us from the previous errors of orthodoxy when it came to the economic crisis? Partly, it was the fault of a few high-profile economists such as Shiller, Akerlof, Krugman, and Lo, whose “behavioral” credentials within the community were, shall we say, less than robust. Partly it was due to some political appointees in the Obama administration such as Cass Sunstein who claimed (falsely, as it turned out) that behavioral economics could be used to “nudge” people into behaving more like neoclassical agents.52 Partly, it was the fault of a few bona fide behavioral finance economists (like Andrei Shleifer), who quickly whipped up a couple of toy models after the crisis, purportedly demonstrating that all agents are beset with a peculiar character flaw that causes them to ignore unlikely disastrous events, causing them to whipsaw around the true fundamental determinants of asset prices as defined by the orthodox rational-expectations model, in the face of securitization and tranching.53 But it also emanated from the vast scrum of journalists, primed to believe that once economists would just abjure “rational choice theories,” then all would become revealed. It got so bad that two bona fide behavioralists felt impelled to pen an op-ed for the New York Times absolving themselves of any responsibility to explain the crisis:
It seems that every week a new book or major newspaper article appears showing that irrational decision-making helped cause the housing bubble . . . It’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address . . . Behavioral economics should complement, not substitute for, more substantive economic interventions [of] traditional economics.54
Ultimately, the more perceptive journalists acknowledged this: “While behaviorists and other critics poked a lot of holes in the edifice of rational market finance, they haven’t been willing to abandon that edifice.”55 It’s not even clear they have been all that willing to bring themselves to look out the window. The primary benefit of behavioral economics was conjuration of the warm glow that came from feeling like you had changed your economic stripes without having to change your mind, or even your models. Like the Seekers.
2) Renunciation of the Efficient Markets Hypothesis
For those riding the roller coaster of 2008, and retrospectively searching for previous wrong turns, it seemed obvious to focus on the sector wherefrom disasters cascaded one after another like clowns piling out of an auto: namely, Wall Street. Not only had finance become the four-hundred-pound gorilla of the U.S. economy, accounting for 41 percent of all corporate profits in 2007, but it was also the arena where economic theory had seemed to matter to a greater degree than elsewhere, given recourse to formal models to “justify” all manner of activities, from securitization and options pricing to risk management.56 Thus it was fairly predictable that some economists would look to finance theory as the prime locus of error, and rapidly settled upon a single doctrine to scapegoat, the one dubbed the efficient-markets hypothesis (EMH). Paul Krugman became a prominent spokesperson for this option in his notorious “How Did Economists Get It So Wrong?”:
By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient markets hypothesis” . . . which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information . . . And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called “a casino.”
Journalists f
ound the EMH irresistibly seductive to ridicule, with John Cassidy and Justin Fox attacking it at length. The journalist Roger Lowenstein declared, “The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.”57 There was more than sufficient ammunition to choose from to rain fire down on the EMH, not least because it had been the subject of repeated criticism from within the economics profession since the 1980s. But what the journalists like Cassidy, Fox, and Lowenstein and commentators like Krugman neglected to inform their readers was that the back and forth, the intellectual thrust and empirical parry, had ground to a standoff more than a decade before the crisis, as admirably explained in Lo and MacKinlay, A Non-Random Walk Down Wall Street:
There is an old joke, widely told among economists, about an economist strolling down the street with a companion when they come upon a $100 bill lying on the ground. As the companion reaches down to pick it up, the economist says, “Don’t bother—if it were a real $100 bill, someone would have already picked it up.” This humorous example of economic logic gone awry strikes dangerously close to home for students of the Efficient Markets Hypothesis, one of the most important controversial and well-studied propositions in all the social sciences. It is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice, and yet is surprisingly resilient to empirical proof or refutation. Even after three decades of research and literally thousands of journal articles, economists have not yet reached a consensus about whether markets—particularly financial markets—are efficient or not.
What can we conclude about the Efficient Markets Hypothesis? Amazingly, there is still no consensus among financial economists. Despite the many advances in the statistical analysis, databases, and theoretical models surrounding the Efficient Markets Hypothesis, the main effect that the large number of empirical studies have had on this debate is to harden the resolve of the proponents on each side [my italics]. One of the reasons for this state of affairs is the fact that the Efficient Markets Hypothesis, by itself, is not a well-defined and empirically refutable hypothesis. To make it operational, one must specify additional structure, e.g., investors’ preferences, information structure, business conditions, etc. But then a test of the Efficient Markets Hypothesis becomes a test of several auxiliary hypotheses as well, and a rejection of such a joint hypothesis tells us little about which aspect of the joint hypothesis is inconsistent with the data. Are stock prices too volatile because markets are inefficient, or is it due to risk aversion, or dividend smoothing? All three inferences are consistent with the data. Moreover, new statistical tests designed to distinguish among them will no doubt require auxiliary hypotheses of their own which, in turn, may be questioned.
This imperviousness of an isolated hypothesis to definitive empirical rejection, and the crucial role of auxiliary hypotheses in serving as a protective barrier, is familiar in the philosophy of science literature as Duhem’s Thesis. The mere fact of deflecting disconfirmation onto harmless auxiliary hypotheses is not prima facie an illegitimate ploy; it occurs in all the natural sciences. The issue was not that immunizing stratagems had been resorted to in this instance; rather, it was that the EMH had proven so rabidly tenacious within orthodox economics and in business schools, occupying pride of place for decades within both macroeconomics and finance, that economists had begun to ignore most modern attempts to disprove it. The lesson for crisis watchers that we shall entertain is that the EMH cannot be killed easily, and maybe not at all within the neoclassical parameters of the current economics profession. That is one reason noneconomists need to be suspicious of claims such as the pronunciation of the economist most famous for the “reject the EMH” option, Joseph Stiglitz:
[A] considerable portion of [blame] lies with the economics profession. The notion economists pushed—that markets are efficient and self-adjusting—gave comfort to regulators like Alan Greenspan, who didn’t believe in regulation in the first place . . . We should be clear about this: economic theory never provided much support for these free market views. Theories of imperfect and asymmetric information in markets had undermined every one of the “efficient market” doctrines, even before they became fashionable in the Reagan-Thatcher era.58
Pace Stiglitz, each blow just seemed to leave it a little stronger. One of the characteristics of the EMH that rendered it impervious to refutation was the fact that both proponents and critics were sometimes extremely cavalier about the meaning and referent of the adjective “efficient.” Both Krugman and Stiglitz, for instance, in the above quotes simply conflate two major connotations of efficiency, namely, “informational efficiency” and “allocative efficiency.” The former is a proposition about the efficacy and exactitude of markets as information-conveyance devices; the latter is a proposition that market prices correctly capture the “fundamentals” and maximize the benefits to market participants by always representing the unique arbitrage-free equilibrium. It is sometimes taken for granted that the former implies the latter; this is the gist of the comment that one will never find loose hundred-dollar bills on the sidewalk. However, if one rephrased the claim to state that no one will ever find valuable unused information on the sidewalk, then the fallacy starts to become apparent.59 In order to respect the significance of that distinction, in this section we deal with those reformers who propose that the orthodoxy shed the information-processing version of the EMH in reaction to the crisis; while in the next section we consider those who seek to dispense with allocative efficiency altogether.
The key to the EMH is to insist that there are some rock-solid “fundamentals” that determine equilibrium price. If one accepts that premise, then orthodox finance economists assert that the EMH “simply comprises the testable implications of arbitrage.” Even Chicago economists such as Luigi Zingales would concede that under certain circumstances asset prices might diverge from these fundamentals; but quickly add that economists had come up with theoretical reasons why these divergences assumed the trajectories we observe. “Thus far, the recent crisis has not provided any critical new evidence on the deviations of markets from fundamentals, only evidence of the costs of these deviations.” The Fed chairman, Ben Bernanke, would concur, adding only that the EMH informs us that we can identify these divergences as “bubbles” only after the fact, so the only “rational” monetary policy should be to clean up the mess afterward. Conveniently, the EMH was then elevated to a self-reflexive theory of the economics profession: they are still paying us after the crisis, so we must be doing something right! “When the definitive history of the EMH is written, the 2007–8 financial crisis will not emerge as a major turning point.”60
The journalist and blogger Felix Salmon posed the critical question during the crisis: Why did the EMH become Dulcinea in the destructive love affair that the economics profession seemed unable to shake off ?61 To appreciate the question, one must become acquainted with a little bit of history. The role of the EMH should be situated within the broader context of the ways that neoclassical economics has changed over time.62 In a nutshell, neoclassical economics looks very different now than it did at its inception in the 1870s. From thenceforth until World War II, it was largely a theory of the allocation of scarce means to given ends. Although trade was supposed to enhance “utility,” very little consideration was given to what people knew about commodities, or how they came to know it, or indeed, about how they knew much of anything else. The Socialist Calculation Controversy, running from the Great Depression until the Fall of the Wall, tended to change all that. In particular, Friedrich Hayek argued that the true function of the market was to serve as the greatest information processor known to mankind. Although Hayek was not initially accorded very much respect within the American economics profession before the 1980s, nonetheless, the “information processing” model of the market progressively displaced the earlier “static allocation” approach in the preponderance of neoclassical theo
ry over the second half of the twentieth century. As one can appreciate, this profoundly changed the meaning of what it meant to assert “the market works just fine,” at least within the confines of economics.63 “Efficiency,” a slippery term in the best of circumstances, had come increasingly to connote the proposition that the market could package and convey knowledge on a “need to know” basis in a manner that could never be matched by any human planner.
Once one recognizes this distinct trend, then the appearance of the EMH in 1965 in Samuelson and Fama, and its rapid exfoliation throughout finance theory and macroeconomics, becomes something more than just a fluke. Indeed, the EMH served as the first bedrock theoretical tenet of the nascent field of “financial economics” in the late 1960s. Almost every trademark model, from CAPM to the Black-Scholes model of option pricing, has it built in. Most academic financial engineers treat it as an inviolate premise. The notion that all relevant information is adequately embodied in price data was one incarnation of what was fast becoming one of the core commitments of the neoclassical approach to markets, not to mention the First Commandment of models of financial assets. It has subsequently been built into the models that inform and conduct trading on all the world’s major exchanges. Of course, the fact that numerous ineffectual attempts were made along the way to refute the doctrine in specific instances (variance bounds violations, the end-of-the month effect, January effect, small-cap effects, mean reversion, and a host of others) did not impugn the EMH so much as quibble over just how far the horizon would be extended. The EMH spawned reams of econometric empiricism, but surprisingly little alteration in the base proposition. The massive number of papers published on the EMH merely testified to the Protean character of the idol of “market efficiency,” which grew to the status of obsession within the American profession.64
Never Let a Serious Crisis Go to Waste Page 35
