Myth of the Rational Market


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Hardcover
382 pages
ISBN 9780060598990 Published June 2009
HarperBusiness
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Myth of the Rational Market
A History of Risk, Reward, and Delusion on Wall Street
By Justin Fox 

Related Blog Posts
In the Books - Off to the Printers XIII
Posted Jan. 13, 2011 7:57 a.m. by dylan
In - 800 CEO Read Blog

The article below was printed in last year's In the Books—our annual review of the best in the business genre. It my (possibly ill-advised) attempt to look at how some of the books published in 2009 tackled the macroeconomic issues, with a (possibly ill-advised) splash of Candide thrown in awkwardly, for emphasis. If you don't feel like reading the entire essay on the topic, you can skip to the end of the post and see F.A. Hayek and John Maynard Keynes argue the points much more eloquently in a battle rap.

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Garden Economy BY DYLAN SCHLEICHER

Voltaire’s Candide was released in 1759, largely as a rebuttal to Gottfried Leibniz’s “best of all possible worlds” version of determinism, or Leibnizian optimism (since God is good and omnipotent, and since He chose this world out of all possibilities, this world must be good—in fact, this world is the best of all possible worlds). Candide’s tutor, Pangloss, schools him in this optimism, but after he is forced out of his “magnificent and most agreeable of all possible castles,” he is painfully disillusioned by the great hardships he endures and bears witness to in the real world.

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“This is the worst economic crisis we’ve faced since the great depression.”How many times have we heard that phrase, or a variation thereof, uttered in the past year and a half? And it rings all too true in our lives. Unlike past economic downturns, we’ve all felt the effects this time around—rich and poor alike, and everyone in between (or what’s left of the in between). We all have friends who have lost their jobs, and the scourge that began and spread this crisis—the real-estate bubble and so-called securities that surrounded it—has turned many of our neighbors out of their very homes.

There were many outstanding books this year that chronicled the collapse, from those focused on the bigger actors like Andrew Ross Sorkin’s Too Big to Fail to those that focus on individual companies (Lawrence G. McDonald’s A Colossal Failure of Common Sense:

The Inside Story of the Collapse of Lehman Brothers and Kate Kelly’s Street Fighters: The Last 72 Hours of Bear Stearns … are among the best of that category). This essay is not about those books. It would take more space than I have to get into those details, and there is a larger discussion happening that I think deserves attention here.

I will look at what this year’s business books have to say on how, exactly, we came to this point in economic history, and what some of the authors in the genre offer as a way out. The issues dealt with in these books are many, but I will distill them into three of the bigger themes: whether markets are inherently rational and should be treated as such; what that may have to do with the crisis we find ourselves in and; what the government’s role should be in the matter.

THE BACKGROUND

To start that story, we have to go back to just before the Great Depression. It was then (in 1906 to be exact) that Yale Professor Irving Fisher published The Nature of Capital and Income, an academic tome that was one of the first

works to claim that there was a fundamental rationality—even scientific order—to markets. He attempted to create mathematical models that would reveal that order and predict it’s movements (primarily, of course, to play in the market). It wasn’t a bestseller by any means, but Fisher’s work had a great deal of influence on economics in academia over the years and is part of the foundation of the complex financial instruments we see on Wall Street today. In The Myth of the Rational Market, the editor-at-large of Time magazine, Justin Fox, tells the story further:

“He is perhaps not the father, but certainly a father of modern Wall Street. Hardly anyone calls him that though. Economists honor Fisher for his theoretical breakthroughs, but outside the discipline his chief claim to lasting fame is the horrendous stock market advice he proffered in the late 1920s. Read almost any history of the years leading up to the great crash of October 1929, and the famous Professor Fisher serves as a sort of idiot Greek chorus, popping up every few pages to assert that stock prices had reached a ‘permanently high plateau’” (5).

Though Fisher was thus debunked in the real-world environs of Depression-era Wall Street, Fisher’s theories had garnered enough serious academic attention to gain a following amongst those interested in economic theory around the world. Fox follows this thread of influence through academia to its ideological apex—the campus of the University of Chicago in the 1960s. This “Chicago School” of economists, most notable among them Milton Friedman, believed not only that the market was fundamentally sound and rational, but that government involvement was a negative interference best left out of the equation. As Fox puts it:

“ … most economists of the day saw government as the solution to economic problems, while the Chicagoans were convinced that government was the problem” (90).

This was a pretty drastic departure from the Keynesian orthodoxy that had ruled in Washington since the depression.

John Maynard Keynes believed in government involvement in markets—indeed, thought it essential. Robert Skidelsky explain it simply in Keynes: The Return of the Master:

“Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks happening in the first place.” (xiv).

As Fox notes in The Myth of the Rational Market, the root of the Chicago School’s disbelief in government involvement stemmed partly from their real world experience of having worked in New Deal Washington, “where they became disillusioned with government attempts to manage the economy.” It also stemmed from a more academic experience, as they themselves stated, from reading Friedrich Hayek’s 1944 book, The Road to Serfdom. Again, from Fox:

“Having experienced the socialist ‘Red Vienna’ of the 1920s and watched the Nazi takeover of his homeland from afar, Hayek was appalled by the equanimity, even enthusiasm, with which Keynes and other English liberal intellectuals greeted the growth of government” (90).

As to whether or not the government should step into the markets during recessions, there seems to be agreement there. Even Milton Friedman, who believed government is the problem and not the solution to problems, believed it should step in when panic strikes. David Wessel explains in In Fed We Trust—his book on Ben Bernanke and The Federal Reserve’s response to the current crisis:

“The lasting lesson [of the Great Depression]—taught by economists with views as different as John Maynard Keynes and Milton Friedman, the leading economic minds of the twentieth century—is embraced almost universally by politicians and economic policy makers: government can and should act to prevent such a dangerous downward financial and economic spiral” (46).

In fact, Bernanke cited Friedman often in his arguments for government intervention:

“The government might, [Bernanke] suggested, cut taxes, increase the federal deficit, and issue bonds that the Fed would buy by printing money. This, he said, was ‘essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.’ (Friedman used the line in 1969 to argue that depression and deflation were avoidable. If nothing else worked, the Fed could send a helicopter to drop dollar bills to get people spending.)” (78).

THE SCIENCE?

So, though he felt the government, in the form of the Fed, should step in when panic struck the country, he believed the market was normally rather rational and should be unfettered by government. Heinrich Hayek, however—the man Friedman partly credited for his general lack of trust of government meddling in the market—wasn’t himself a proponent of the Chicagoan’s bedrock philosophy that the market is inherently rational, that economics itself was a “science.” Joshua Cooper Ramo, in The Age of the Unthinkable, relates Hayek’s response to winning The Nobel Prize in 1974:

“‘The Nobel Prize,’ he began, ‘marks a significant step in the process by which, in the opinion of the general public, economics has been conceded some of the dignity and prestige of the physical sciences.’ But Hayek said, he wondered just how much of that prestige was really justified. ‘Economics are at this moment,’ he continued, ‘called upon to say how to extricate the free world from the serious threat of accelerating inflation, which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things’” (38, 39).

As Hunter Lewis writes in Where Keynes Went Wrong:

“The question of whether economics is a science is briefly discussed in this author’s Are the Rich Necessary? The conclusion reached there is that economics is and never shall be a science. Why? In the first place, when we observe an apple fall from a tree, or deduce the force of gravity, it will not affect what an apple does. But human action, the subject of economics, is entirely different. It is very changeable; it is even changed by what economists tell us about ourselves. If economists tell us that stocks are the most reliable long-term investment, we all buy stocks and the prices will soar. Eventually there will be no more sellers, the price will collapse, and we will discover we have made a very bad investment. We saw that well enough in the 1920s and 1990s. So, on a whole, it is much better to accept that economics is trying to sort out possibilities, not truths, and is closely aligned with moral philosophy, also known as values” (44).

THE SOLUTION?

As we’ve seen, the financial instruments that have been put to use on Wall Street recently have not made money—they have engineered it. They have not made profits, but engineered them, sometimes with Keynesian motives for greater well-being, but with disregard to Keynesian principles.

In Free the Market!, Gary L. Reback looks to strike a balance, writing:

“Most markets neither require nor profit from extensive government regulation” (2).

But he goes on to argue that the proponents of systematic deregulation—specifically calling out the Chicago School and the weakening of anti-trust laws—has made markets less free:

“In our modern economy, Chicago School policies only serve to damage free market capitalism (and consumers specifically) by entrenching incumbents, retarding innovation, and making life miserable for entrepreneurs. Yet the Chicago School has been difficult to dislodge, notwithstanding its questionable record of protecting consumer welfare, because it is much more than just an enforcement policy. It is what one conservative economist called ‘a system of belief’” (4).

Both Keynes and Friedman, the two giants of economics in the 20th century, had something that will be invaluable to us in the 21st—intellectual flexibility. Friedman, who was staunchly opposed to government meddling in markets, knew there was a time for it. Keynes is often viewed as more of a philosopher than an economist. And Hayek, a strong proponent of deregulation (and, remember, the man The Chicago School of Economists credited for forming their stance against government involvement in the market) counseled a “nurturing” flexibility. Returning to The Age of the Unthinkable and his Nobel speech:

“Hayek warned, ‘If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible.’ Politicians and thinkers would be wise not to try to bend history as ‘the craftsman shapes his handiwork, but rather to cultivate growth by providing the appropriate environment, in the manner a gardener does for his plants’” (40).

But, if the markets can’t be trusted to be rational, and the government can’t be trusted at all, how exactly is the economic garden to be tended? Who, exactly, are the “gardeners” of our federal economy? Does the responsibility go to the economists at the Federal Reserve—who Stephen H. Axilrod defines as “independent within the government”—and, if so, how exactly will they tend the economic garden? Will they allow it to flourish wildly in it’s natural environment, sticking to the strictures of a rational market that can tend itself, or will they weed out what they see as undesirable elements with regulatory measures, creating a rational response to and oversight of the market? Axilrod describes the actors within the Fed in his insider’s account of the institution, Inside the Fed:

“I have often thought to divide the members of my often all too dour profession of economics between those whose approach might be very loosely considered poetic (not too many of them) and those who are basically scientific (large in numbers). The former are more intuitive, more prone to the sin of ‘casual empircism,’ and often more involved in the practical aspects of economics, such as (in my case) interactions between, on the one hand, monetary policy and, on the other, the behavior of often skittish and unpredictable market participants and the public more generally” (18).

He sees the “poets” as artists who can take the public stage and articulate the need for the Fed’s actions to control inflation and restore confidence in the market (and in the population itself) when it wanes.

As Reback stated in Free the Market:

“The benefits of the free market don’t come free. Competition must be nurtured and protected by the government, as Americans first discovered more than a century ago, in a turbulent time driven by technological change, an era not unlike our own” (2).

THINKING OUTSIDE THE BANKS

I’d feel remiss not mentioning at least two authors that counsel throwing our current system completely out the window. On the libertarian front, there is Ron Paul. Though most current observers see the government and Fed as indispensable, Ron Paul sees it as corrupt, counterproductive and even unconstitutional. Contrary to what the Fed itself sees as it’s primary role—controlling inflation—Paul believes it only adds to the problem by printing more money. In End the Fed, he writes:

“Ending the Fed is the one sure way to restore sanity to economic and political life in this country. It doesn’t mean that our political disagreements and fights in Congress will go away. Ending the Fed is not a magic pill to usher in Utopia. But it does mean that our disagreements and discussions will occur within the context of reality, not in the illusory world created by the unlimited printing of money” (8).

On the liberation front, there is Douglass Rushkoff who suggests that not only would we be better off having let banks fail, but that we need to break the hold the corporate model has on our very lives. He takes the narrative back all the way to the Middle Ages, when monarchies began replacing local currency with state currencies and setting up monopolies.

“The Renaissance was never about extending … prosperity but about monopolizing it. … the chartered corporation was at its core a scheme to lock in the recent success of … rising merchants” (167).

THE CONCLUSION

In some circles over the last three decades, to question the fundamental soundness of free markets was akin to questioning America itself—and “free market” was narrowly defined as unregulated, unfettered markets. The view seemed to be “This market is the very best of all possible markets.” And to meddle in it was to interfere with the “invisible hand” guiding it, which was economic blasphemy.

The pendulum seems to be swinging heavily the other way. It’s hard for many to see what has happened since the markets have been largely deregulated as anything nearing “rational.” The idea of a free market itself is being redefined. Just as traffic laws allow one to drive down the street safely—free from reckless road conditions—the government now seems intent on reestablishing order on Wall Street so that the general public feels safe there again. To many, it looks like the only rational thing to do.

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Like us, Candide once lived in great splendor, with an abiding faith that he inhabited the best of all possible worlds. When he was forced from his home and assaulted by the ugly realities of an often unjust world, he lost some of that faith, and stresses the work it takes to maintain vitality. Near the end of the book, his old mentor Pangloss tries to put a Leibnizian spin on the ordeals of Candide’s life:

“There is a concatenation of all events in the best of all possible worlds; for, in short, had you not been kicked out of a fine castle … ; had you not been put into the Inquisition; had you not traveled to America on foot; had you not run the Baron through the body; and had you not lost all your sheep … you would not have been here to eat preserved citrons and pistachio nuts.”

“Excellently observed,” replied Candide; “but we must cultivate our garden.”

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PREVIOUS POSTS FROM IN THE BOOKS



Friday Links
Posted April 16, 2010 9:35 a.m. by dylan
In - 800 CEO Read Blog

➻ Justin Fox, author of The Myth of the Rational Market, pondered Improving the Let's-Persuade-Business-to-Improve Movement in a recent Harvard Business Review post. There's a lot of folks out there writing about we can persuade business and those in it to behave more ethically, but Fox thinks its still a hard sell:

I don't think anyone has come up with an argument for or description of better business behavior that has anything like the elegance and power of the economists' "incentives matter."

He ends, understandably, on a slightly defeated note, writing: "Clearly, I'm stuck here. Can somebody help me out?" Umair Haque, his colleague at HBR tried to answer his call for help, making The Case for Being Disruptively Good, arguing for the forces of information, discipline, competition, disruption and rule-making. He writes:

So why don't more businesses see these forces? It's the wrong question. The right one is: because there will be some organizations that are quicker to get it than others, what do the forces above mean for the economy? Well, they suggest that businesses who can do more good will survive, thrive, and prosper — and those who do more bad will stumble, falter, and fall.

I think he's definitety right, but he is taking a pretty long view of history when he writes: "Yesterday, the global economy was built on debtors' prisons, usury, expropriation, colonialism, and slavery. Today, it isn't." and "Yet even two hundred years from now, I'm sure incumbents will ask—what, you want us to do more good? And then, as ever, from under their patrician noses, revolutionaries who can do better will disrupt them." And while Umair's language speaks to me, I don't know if it is as catchy as "incentives matter" to those marching off to Wall Street. As Dr. Martin Luther King Jr. said, "The arc of the moral universe is long, but it bends toward justice."

➻ Richard Florida also takes a longer view in his works about the creative class—such as The Rise of the Creative Class—and he has a great new book coming out in May called The Great Reset. You can get a taste of the book in his March article in The Atlantic, How the Crash Will Reshape America, or by reading his recent interview with Conor Clarke for the same magazine.

➻ Portfolio has posted a new issue of The Business Beat. Featured this month are Peter Escher, author of The MBA Oath, Michael O'Malley, author of The Wisdom of Bees, and, as always, our own peerless leader Jack Covert in his Just Jack corner. Jack discusses Po Bronson's What Should I Do With My Life, one of The 100 Best Business Books of All Time and a close second (in my mind) to Studs Terkel's Working as the best book of interviews ever created about work.

➻ Speaking of The 100 Best Business Books of All Time, you can now read it in Indonesian.* Muhammad Mishbah penned a review for Seputar Indonesia Daily writing:

Books 100 Best Business Books of All Time provides 100 units with a discussion of book selection of different problems. This book is like a "dictionary" of business books that point us in order to save time, money and energy before seeking appropriate books.

(Shakes fist at Google Translate.)

*This applies only to those of you that can actually read Indonesian.

➻ Peter Elkind's new book, Rough Justice: The Rise and fall of Eliot Spitzer, is embargoed until next Tuesday, but you can get a preview at Fortune, blessed as they were with an an exclusive excerpt. "'Is there a way to wire money where it's not evident that it's coming from me?' the governor asked."

➻ The Web Designer Depot posted a great overview of Scott Belsky's Making Ideas Happen by Cameron Chapman. He writes "Making Ideas Happen is an excellent resource for those of us who have no shortage of ideas but often have a hard time seeing those ideas through to completion." That is everyone I know, including me and probably you.

➻ Roger C. Parker has a novel idea: Learn to write a business book by studying 800-CEO-READ’s Top 25 Business Books.

➻ "Some people seem to think life is all about the I, and the Me, Me, Me." The WePad begs to differ. (HT to Siobhan O’Leary at Publishing Perspectives.)

➻ Following the Freakonomics trend, America's finest news source, The Onion, reported recently that "last month's quarter-inch drop in height among Mexican dead-lift competitors in the middle-heavyweight division could spell disaster for GE's aviation and software subsidiaries." "But, like anything else, a shrewd investor must always ask himself one thing: How many hot dogs did I eat last year?"

➻ I'll ask her someday.



The 800-CEO-READ Business Book Awards of 2009
Posted Dec. 15, 2009 3:00 a.m. by dylan
In - 800 CEO Read Blog

The 800-CEO-READ Business Book of the Year

Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—And Themselves by Andrew Ross Sorkin, Viking Books, 624 pages, $32.95

Even though Too Big to Fail was written during the same year the financial collapse occurred, Andrew Ross Sorkin has written what we predict will be the definitive book on the subject. Sorkin not only tells a gripping “perfect storm” story—reporting the gory details as our 401k’s disappeared and our financial system became nationalized—but he humanizes the players as well, resulting in an imminently readable, albeit lengthy, book.

It’s a sobering reflection and a critical reminder of what transpired in recent financial history. But it is the great stories and detailed, insider information—the sense one gets of being in the room while history is being made—that will place this book among the greats.

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Leadership

best in category ➻ Maestro: A Surprising Story About Leading By Listening by Roger Nierenberg, Portfolio, 128 pages, $19.95 | Leadership is something that can be learned. However, the most respected leaders are not textbook cases, but those who wield the necessary traits and knowledge with a very personal sense of purpose. A parable, which Maestro is, is an ideal way to create a scenario for that sense of purpose to develop, as ideas are presented in ways that are interpreted personally by those who read them, rather than listed as bullet points or chapter summaries. By using the metaphor of a conductor and his orchestra, important details are revealed, from interpersonal communication skills, individual effort to benefit the group, group dynamic to celebrate the individual, and the role that listening (both physically and intuitively throughout all experience) plays in creating the most successful results.

best of the rest:

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Management

best in category ➻ The Four Conversations: Daily Communication That Gets Results by Jeffery Ford & Laurie Ford, Berrett-Koehler, 238 pages, $19.95 | At the core of management is the practiced skill of communication. The Fords present four kinds of the conversations and the best situations to use each of them. More performance conversations (asking for promises) and less understanding conversations (are you OK with all of this?) are needed, they say.

best of the rest:

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Marketing & Advertising

best in category ➻ Trust Agents: Using the Web to Build Influence, Improve Reputation, and Earn Trust by Chris Brogan & Julien Smith, John Wiley & Sons, 271 pages, $24.95 | Social Media took off in big ways this year, and while technology has become an important tool for communication, marketing, and advertising, Trust Agents reels the tech-excitement back in by advocating a not-so-new element that is essential: trust. If the people who put out the messages aren’t people we’d like to work with and buy from, their messages, no matter how easy to broadcast, won’t hold their weight. It’s not about how to master technology, but about being the kind of person, the kind of company, that people like to do business with. This book is filled with prime examples, great stories, and hard facts that convince us not to be blinded by innovation as we communicate with our audiences.

best of the rest

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Sales

best in category ➻ A Seat at the Table: How Top Salespeople Connect and Drive Decisions at the Executive Level by Marc Miller, Greenleaf Publishing Group, 174 pages, $19.95 | In A Seat at the Table, Marc Miller shows that selling is based on the simple concept that the only thing a customer desires is value. The value this book will have for salespeople is that in the discussions of the customers need for value, Miller guides the reader step by step how to provide strategic help for their customers and deliver new and different forms of value.

best of the rest

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Finance & Economics

best in category ➻ False Economy: A Surprising Economic History of the World by Alan Beattie, Riverhead Books, 321 pages, $26.95 | Alan Beattie not only provides engrossing snapshots of mankind’s economic history; he demonstrates how naturally fragile economies are—and continue to be—and how they are guided by the choices we make, not by some invisible hand. It’s a great lesson in these uncertain times that we are—or at least can be—in control of our own economic future.

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Entrepreneurship & Small Business





best in category ➻ Escape from Cubicle Nation: From Corporate Prisoner to Thriving Entrepreneur by Pamela Slim, Portfolio, 340 pages, $25.95 | “Should I go solo?” The collapse of companies and careers over the last year has many asking themselves exactly that question. It’s the avalanche of concerns that follow like “What would I do?” to “Do I have enough money?” that stop most. The power of Escape from Cubicle Nation is that it removes all the roadblocks to saying “Yes.”

best of the rest

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Biographies & Narratives

best in category ➻ The Match King: Ivar Kreuger, the Financial Genius Behind a Century of Wall Street Scandals by Frank Partnoy, PublicAffairs, 272 pages, $26.95 | In The Match King, Frank Partnoy brings Ivar Krueger, the match king, and exciting (though terrifying) time to life. We learn how he cornered the market on matches in his native Sweden and using “creative” accounting was able to ride that success to riches beyond belief until the market collapsed and so did his house of cards. So brilliant is Partnoy’s portrayal that I wanted to keep reading the book even as I walked to my car from the office at night. A great story, told well—there is nothing better.

best of the rest

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Current Interest

best in category ➻ Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—And Themselves by Andrew Ross Sorkin, Viking Books, 624 pages, $32.95 | How could we not pick a book on the financial crisis to lead the Current Interest category this year? And if we are going to pick a book on it, how could it not be this one? Too Big To Fail is the definitive book on the events leading up to, as well as on the characters involved in, the financial meltdown. In his reporting, Andrew Ross Sorkin has managed to weave together an entertaining narrative and recreate a nearly unbelievable sequence of events on Wall Street and in Washington—one that will likely be referenced as long as the topic is studied.

best of the rest

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Personal Development

best in category ➻ Power of 2: How to Make the Most of Your Partnerships at Work and in Life by Rodd Wagner & Gale Muller, Ph.D., Gallup Press, 243 pages, $24.95 | Wagner and Muller contend that it is a myth, or a rarity at least, that the best work happens when one heroic person who is somehow more superiorly gifted than average wrestles an insurmountable task and wins. Instead, Power of 2 proposes that a great partnership can more reliably produce transcendent work by capitalizing on the strengths of both persons engaged in the venture. It’s not a surprise then that Power of 2 was published by Gallup Press, the experts on strengths theory, and it is a pleasure to read a book that encourages collaboration based on strong research and communicated through enjoyable stories, particularly at time when many people are more often encouraged to “look out for #1.”

best of the rest

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Innovation & Creativity

best in category ➻ The Design of Business: Why Design Thinking Is the Next Competitive Advantage by Roger L. Martin, Harvard Business Press, 191 pages, $26.95 | Design thinking is a popular trend in innovation thought this year and a number of good books submitted to this category offer various and useful treatments. The Design of Business by Roger Martin lays out the most applicable system to integrating design thinking into an organization or applying it to a singular problem. Martin also shows just how design thinking can reside harmoniously with more analytical or quantitative approach to strategy. Using memorable metaphors, Martin brings his professorial experience to the topic teaching the uninitiated and the theorist alike this new way of problem solving.

best of the rest

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Big Ideas

best in category ➻ What Would Google Do? by Jeff Jarvis, HarperBusiness, 257 pages, $26.99 | Don’t be confused. This book is not about Google. Jarvis is delivering the virtues of clickable, linkable, searchable, and transparent using the Internet powerhouse as the metaphor. The thought experiments in the final third of the book (Google Cola, Google Capital, and The United States of Google to name a few) make concrete the ways in which the web is quickly changing what we expect from those who serve us.

best of the rest

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