Markets are not rational

A key premise of most financial theory is that markets are always rational and correctly price all assets. Under this logic there is no such thing as a bubble. Alan Greenspan did and still does believe this. Yet bubbles do exist, are common, and, in fact, are more the norm than the exception. Greenspan argued that even if bubbles exist they can not be detected, which is really circular logic based on the assumption the market is always right and therefore nothing can be measured to indicate a bubble.

I think there are three arguments that are widely accepted but may also be flawed:

  1. markets are always rational
  2. markets “efficiently” price assets, always accounting for all information rationally
  3. “risk” can be measured, as volatility, through historical statistical measures

All the models that sunk the U.S. financial system in 2008 are based on these ideas. Now in hindsight it can easily be seen that #3 is false, because historical information was: a) insufficient in quantity, esp. for the types of assets being created in the first decade of the 21st century, and, b) volatility is a technical measure, not a fundamental one, and is based on several false statistical ideas, that is, correlation of zero (clearly false in housing, but totally believed up until September 2008) and the statistics fit well-known patterns, like Gaussian distributions (even though every knows about fat tails and long tails, they discount these as anomalies).

Now there is a new study that asserts two ideas: 1) Greek debt pricing was/is irrational, and, 2) this non-equilibrium irrationality can be detected (basically by looking at more fundamental, rather than simply technical, factors). While this study looks at aggregate measures it doesn’t seem to suggest any underlying model of the irrationality. Massive disruption to large numbers of people is occurring simply because markets are wrong; corrections do occur but in a timeframe that permits non-equilibrium behavior to continue.

So I’ll suggest a simple concept for irrationality. The actual players in the market (traders) are compensated (too much) by trading activity, not ultimate success or failure of investments. And actual investors no longer base their trading strategy on investment fundamentals, but in fact, are subject to the pressures of the traders who will sell anything they can to the credulous, just to get the fees, because they know there won’t be any long-term accountability. That is, Goldman Sachs can con institutional investors and cost them substantial losses, but those investors won’t judge GS on their terrible advice, but just keep coming back for more.

This suggests to me that the instability in the financial system will increase, esp. as any attempt at reform has been blocked by the corruption of the political system, who like the traders, only look at their short-term gain (campaign funding). Tweaking the system with little baby-steps isn’t going to do anything so it’s time for a broad-ax slashing through this broken system:

  1. completely separate proprietary trading from trading for customers
  2. radical reform of compensation, esp. tying it to long-term results, with clawbacks for mistakes
  3. busting the Too Big To Fail firms so there is some competition and thus the “herd” mentality is broken and the institutional investors (and hedge fund investors) have to do their research and do business with banks that actually do some good
  4. far more transparency so that studies can be done and contrary points of view developed, as well as providing regulators something to work with.

Now it’s unlikely any of this will happen, at least in the U.S., so look for continued instability, quite possibly enough to create global complex. The financial theory crowd needs to get out of their reductionist POV and start looking at systemics, but most of the “rational” economist crowd needs to be firmly challenged by the behaviorist crowd.


About dmill96

old fat (but now getting trim and fit) guy, who used to create software in Silicon Valley (almost before it was called that), who used to go backpacking and bicycling and cross-country skiing and now geodashes, drives AWD in Wyoming, takes pictures, and writes long blog posts and does xizquvjyk.
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