Roylat.com

Today’s New York Times has an article entitled “Poking Holes in a Theory of Markets.” Joe Nocera, the author, interviews Jeremy Grantham and several academic economists. The article makes what is now an obvious challenge to the theory of “efficient markets,” the theory that markets accurately reflect at all times the best possible valuation of stocks and assets given current information. This is a version of the old debate in Wall Street about whether or not one can do better than simply to invest in an index fund. Of course, in the current situation, it has much broader ramifications, because the efficient market argument underlay the justification for extremely lax, haphazard regulation of investment firms and the reluctance of the Federal Reserve and Congress to rein in the speculative binge in housing and mortgage financing.

The article itself is not all that insightful, but what caught my eye was a reference to Robert Shiller, and following that reference did lead me to useful insights. You may recall that Robert Shiller is most widely cited because of the Case-Shiller index of housing prices, an index that captures current housing prices much better than the government index. Shiller is also justly recognized for being an early, persistent alarmist about the housing bubble and the likelihood that when it burst it would do serious economic damage. He did not foresee the magnitude of the calamity, but he shouldn’t be criticized for what no one really foresaw.

To me, what stands out is that Shiller is a full-fledged establishment economist, a full professor at economics and finance at Yale University. As far as I can tell, just about every establishment economist is completely at a loss when it comes to understanding the real economy, that is, the economy that matters to those of us who need jobs, food on the table, the ability to pay for health care, to educate our children, and hopefully, eventually to retire. Establishment economists live in a world of ever expanding production (measured by GDP, which includes all the negatives as positives), where any and all problems are overcome by further increases in production. In this world, stock prices, housing prices, and commodity prices are just not all that important, because they don’t relate to what they consider real, that is real, that is, inflation-adjusted GDP.

Now, of course there is the legion of mathematical economists who migrated wholesale to the big financial firms over the last 20-30 years, but they have had no interest in the real economy either, only in how to use mathematics and statistics to more accurately price assets (ignoring the contradiction between this task and the belief in the theory of efficient markets). There is no doubt that some of this work led to outsize profits for them and their employees, but most of these profits came not from truly better valuations but from using huge amounts of credit to multiply their ability to profit from small imperfections in the market. Hardly any of them saw further than the next bonus check.

Robert Shiller is evidently cut from different cloth. He first published Irrational Exuberance in early 2000, before the dot-com bubble burst. He published the second edition in 2006, warning of the unjustified housing bubble.

Not only did he address the general public, but he tried to warn policy makers – although he explains his timidity in doing this in a New York Times article of November 1, 2008, “Challenging the Crowd in Whispers, Not Shouts". In this article, Dr. Shiller gives his view of why everyone, including himself, is reluctant to object too loudly to a widely held consensus view. He cites his experience with the housing bubble.

For example, I clearly remember a taxi driver in Miami explaining to me years ago that the housing bubble there was getting crazy. With all the construction under way, which he pointed out as we drove along, he said that there would surely be a glut in the market and, eventually, a disaster.

But why weren’t the experts at the Fed saying such things? And why didn’t a consensus of economists at universities and other institutions warn that a crisis was on the way?

The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group.

…

From my own experience on expert panels, I know firsthand the pressures that people — might I say mavericks? — may feel when questioning the group consensus.

I was connected with the Federal Reserve System as a member the economic advisory panel of the Federal Reserve Bank of New York from 1990 until 2004, when the New York bank’s new president, Timothy F. Geithner, arrived. [Note that this was published on November 1, 2008, before the election and before Geithner became Treasury Secretary. Interesting that Shiller left the panel when Geithner arrived. Roylat] That panel advises the president of the New York bank, who, in turn, is vice chairman of the Federal Open Market Committee, which sets interest rates. In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.

…

I gave talks in 2005 at both the Office of the Comptroller of the Currency and at the Federal Deposit Insurance Corporation, in which I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

…

I based my predictions largely on the recently developed field of behavioral economics, which posits that psychology matters for economic events. Behavioral economists are still regarded as a fringe group by many mainstream economists. Support from fellow behavioral economists was important in my daring to talk about speculative bubbles. [Emphasis added. Roylat]

Two aspects of this article stand out: 1) Incorporating social psychology into an understanding of the failure of the market and its overseers to see what should have been obvious, and 2) the fact that there is a field of “behavioral economics.” It seems well worthwhile to learn more about this field of economics – and I’m starting out by getting a copy of Irrational Exuberance . This could prove to be a basic foundation for understanding the waves of over-optimism (and over-pessimism) that sweep over markets with regularity.