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III. PANGLOSSIAN FINANCE
In the 1930s, financial markets, for obvious reasons, didn’t getmuch respect. Keynes compared them to “those newspaper competitions inwhich the competitors have to pick out the six prettiest faces from ahundred photographs, the prize being awarded to the competitor whosechoice most nearly corresponds to the average preferences of thecompetitors as a whole; so that each competitor has to pick, not thosefaces which he himself finds prettiest, but those that he thinkslikeliest to catch the fancy of the other competitors.”
And Keynes considered it a very bad idea to let such markets, inwhich speculators spent their time chasing one another’s tails, dictateimportant business decisions: “When the capital development of acountry becomes a by-product of the activities of a casino, the job islikely to be ill-done.”
By 1970 or so, however, the study of financial markets seemed tohave been taken over by Voltaire’s Dr. Pangloss, who insisted that welive in the best of all possible worlds. Discussion of investorirrationality, of bubbles, of destructive speculation had virtuallydisappeared from academic discourse. The field was dominated by the“efficient-market hypothesis,” promulgated by Eugene Fama of theUniversity of Chicago, which claims that financial markets price assetsprecisely at their intrinsic worth given all publicly availableinformation. (The price of a company’s stock, for example, alwaysaccurately reflects the company’s value given the information availableon the company’s earnings, its business prospects and so on.) And bythe 1980s, finance economists, notably Michael Jensen of the HarvardBusiness School, were arguing that because financial markets always getprices right, the best thing corporate chieftains can do, not just forthemselves but for the sake of the economy, is to maximize their stockprices. In other words, finance economists believed that we should putthe capital development of the nation in the hands of what Keynes hadcalled a “casino.”
It’s hard to argue that this transformation in the profession wasdriven by events. True, the memory of 1929 was gradually receding, butthere continued to be bull markets, with widespread tales ofspeculative excess, followed by bear markets. In 1973-4, for example,stocks lost 48 percent of their value. And the 1987 stock crash, inwhich the Dow plunged nearly 23 percent in a day for no clear reason,should have raised at least a few doubts about market rationality.
These events, however, which Keynes would have considered evidenceof the unreliability of markets, did little to blunt the force of abeautiful idea. The theoretical model that finance economists developedby assuming that every investor rationally balances risk against reward— the so-called Capital Asset Pricing Model, or CAPM (pronouncedcap-em) — is wonderfully elegant. And if you accept its premises it’salso extremely useful. CAPM not only tells you how to choose yourportfolio — even more important from the financial industry’s point ofview, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizesfor its creators, and many of the theory’s adepts also received moremundane rewards: Armed with their new models and formidable math skills— the more arcane uses of CAPM require physicist-level computations —mild-mannered business-school professors could and did become WallStreet rocket scientists, earning Wall Street paychecks.
To be fair, finance theorists didn’t accept the efficient-markethypothesis merely because it was elegant, convenient and lucrative.They also produced a great deal of statistical evidence, which at firstseemed strongly supportive. But this evidence was of an oddly limitedform. Finance economists rarely asked the seemingly obvious (though noteasily answered) question of whether asset prices made sense givenreal-world fundamentals like earnings. Instead, they asked only whetherasset prices made sense given other asset prices. Larry Summers,now the top economic adviser in the Obama administration, once mockedfinance professors with a parable about “ketchup economists” who “haveshown that two-quart bottles of ketchup invariably sell for exactlytwice as much as one-quart bottles of ketchup,” and conclude from thisthat the ketchup market is perfectly efficient.
But neither this mockery nor more polite critiques from economists like Robert Shiller of Yalehad much effect. Finance theorists continued to believe that theirmodels were essentially right, and so did many people making real-worlddecisions. Not least among these was Alan Greenspan,who was then the Fed chairman and a long-time supporter of financialderegulation whose rejection of calls to rein in subprime lending oraddress the ever-inflating housing bubble rested in large part on thebelief that modern financial economics had everything under control.There was a telling moment in 2005, at a conference held to honorGreenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (ofthe University of Chicago, surprisingly), presented a paper warningthat the financial system was taking on potentially dangerous levels ofrisk. He was mocked by almost all present — including, by the way,Larry Summers, who dismissed his warnings as “misguided.”
By October of last year, however, Greenspan was admitting that hewas in a state of “shocked disbelief,” because “the whole intellectualedifice” had “collapsed.” Since this collapse of the intellectualedifice was also a collapse of real-world markets, the result was asevere recession— the worst, by many measures, since the Great Depression. What shouldpolicy makers do? Unfortunately, macroeconomics, which should have beenproviding clear guidance about how to address the slumping economy, wasin its own state of disarray.
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