Thursday, March 12, 2009

Didn't See It Coming

I was recently going through some files and found an essay by the economist Jeff Madrick in the New York Times with the provocative title: "Market messes happen. And inefficiencies have consequences." Discussing the orthodox view that financial markets efficiently process all information and thus correctly set the prices for financial assets based on available information, Madrick noted that "economists are increasingly challenging the orthodoxy. A growing number argue that according to the best new evidence, financial markets do not appear all that efficient after all." If markets are not as efficient as economists generally thought, he continued, "speculative and dangerous stock market bubbles are entirely possible and even likely, ... the federal authorities must remain vigilant about the complete and open flow of information, and ... the stock market does not necessarily allocate capital investment to the right places."

At this point in the financial crisis, such arguments have become familiar if not commonplace. What makes this interesting is that Madrick published those words on August 3, 2000. Since then, the stock market has tanked not once but twice (see, for example, this historical graph of the Dow Jones industrials), first after the dot-com bubble burst and now with the mortgage-led collapse. Madrick was writing while Bill Clinton was still president, shortly after the Gramm-Leach-Bliley Act dismantled the barriers between various types of financial institutions as part of an effort to deregulate financial markets and allow them to become even more "efficient."

Madrick did not discuss any particular legislation. Instead, he simply pointed out that some very high-powered economists (focusing on Andrei Shleifer, but also mentioning Robert Shiller and Richard Thaler) had been doing important theoretical work that undermined the "efficient markets hypothesis," which was at the heart of the case for financial deregulation. The orthodoxy was so strong, however, that this dissenting work did not penetrate the mainstream. Alan Greenspan has now famously admitted that he was in a state of "shocked disbelief" about the meltdown of the financial markets: "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

Admittedly, it's probably possible to go back a decade and find three economists who seem to have predicted any particular event. But this is not some isolated event. We are talking about the unraveling of the global economy in the wake of decisions that were based explicitly on theories that these dissenting economists debunked. Greenspan and others ignored this unorthodox work not because of some overwhelming body of evidence against it but precisely because it was unorthodox and did not fit with their preconceived view of how markets work.

The resistance by the mainstream to any such unorthodoxy, moreover, affects not just the ideologues but also the undecided -- and even those who see through the nonsense. Last Fall, Shiller discussed his own advisory work with the Federal Reserve and allowed that he had been shy about pushing his views because of "groupthink," saying that those with unorthodox views 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." With wonderful candor, Shiller admitted: "In my position on [a Fed advisory] 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."

Even in the current crisis, there is entrenched resistance to revising cherished presumptions. Economics graduate students at top departments are not being encouraged to look at the work of economists whose work directly addresses the causes and consequences of financial crises, like John Maynard Keynes and Hyman Minsky, because (according to the chair of a top economics department) "graduate students work on subjects — like real models of business cycles — that are at the frontier of the field; by contrast Keynes and Minsky are not on the frontier anymore." You just have to love the power of circular reasoning!

-- Posted by Neil H. Buchanan