Beyond Mechanical Markets

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State

Roman Frydman
Michael D. Goldberg
Copyright Date: 2011
Pages: 304
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  • Book Info
    Beyond Mechanical Markets
    Book Description:

    In the wake of the global financial crisis that began in 2007, faith in the rationality of markets has lost ground to a new faith in their irrationality. The problem, Roman Frydman and Michael Goldberg argue, is that both the rational and behavioral theories of the market rest on the same fatal assumption--that markets act mechanically and economic change is fully predictable. InBeyond Mechanical Markets, Frydman and Goldberg show how the failure to abandon this assumption hinders our understanding of how markets work, why price swings help allocate capital to worthy companies, and what role government can and can't play.

    The financial crisis, Frydman and Goldberg argue, was made more likely, if not inevitable, by contemporary economic theory, yet its core tenets remain unchanged today. In response, the authors show how imperfect knowledge economics, an approach they pioneered, provides a better understanding of markets and the financial crisis. Frydman and Goldberg deliver a withering critique of the widely accepted view that the boom in equity prices that ended in 2007 was a bubble fueled by herd psychology. They argue, instead, that price swings are driven by individuals' ever-imperfect interpretations of the significance of economic fundamentals for future prices and risk. Because swings are at the heart of a dynamic economy, reforms should aim only to curb their excesses.

    Showing why we are being dangerously led astray by thinking of markets as predictably rational or irrational,Beyond Mechanical Marketspresents a powerful challenge to conventional economic wisdom that we can't afford to ignore.

    eISBN: 978-1-4008-3818-9
    Subjects: Economics, Political Science, Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-xii)
  3. Acknowledgments
    (pp. xiii-xviii)
  4. What Went Wrong and What We Can Do about It
    (pp. 1-18)

    Instability is an inherent feature of capitalist economies, perhaps nowhere more markedly so than in modern financial markets. Asset prices and risk tend to fluctuate, and, as recent experience in housing, equity, currency, and commodity markets around the world has shown, upswings in prices sometimes become excessive, eventually ending in abrupt and dramatic reversals.

    These boom-and-bust fluctuations in asset values often lead to painful shifts in consumption and investment patterns that can trigger or prolong economic downturns and sharply increase unemployment. Many observers have pointed to excessive upswings in housing and equity prices as key factors behind the global financial...

    • 1 The Invention of Mechanical Markets
      (pp. 21-40)

      ALTHOUGH THE raison d’être for financial markets implies that they cannot assess asset values perfectly, over the last four decades of the twentieth century, economists developed an approach to macroeconomics and finance that implied that financial markets allocate societyʹs capital almost perfectly. To reach this conclusion, economists constructed probabilistic models that portray an imaginary world in which nonroutine change ceases to be important; indeed, it becomes irrelevant.

      An economic theory of the world that starts from the premise that nothing genuinely new ever happens has a particularly simple—and thus attractive—mathematical structure: its models are made up of fully...

    • 2 The Folly of Fully Predetermined History
      (pp. 41-54)

      IN MODERN ECONOMIES, individuals and companies engage in innovative activities, discovering new ways to use existing physical and human capital, and new technologies in which to invest. The institutional and broader social context within which this entrepreneurial activity takes place also changes in novel ways. And innovation itself influences the future returns from economic activity in ways that no one can fully foresee. Thus, change in capitalist economies is to a significant extent nonroutine, for it cannot be adequately captured in advance with mechanical rules and procedures.

      Because nonroutine activities are an important component of change, investment decisions in modern...

    • 3 The Orwellian World of “Rational Expectations”
      (pp. 55-70)

      THE SEARCH FOR fully predetermined accounts of individual decisionmaking and market outcomes actually predates economists’ embrace of the Rational Expectations Hypothesis as the way to characterize rational forecasting behavior. Prior to this hypothesis, economists portrayed market participants’ forecasting strategies with mechanical rules that made no explicit reference to how they reason about the way the economy works or how the causal process underpinning outcomes might change over time. John Muth proposed the Rational Expectations Hypothesis as a way to incorporate such considerations into models of forecasting. Criticizing pre-REH forecasting rules, he argued that

      the character of dynamic processes is typically...

    • 4 The Figment of the “Rational Market”
      (pp. 71-80)

      IN PROPOSING the Rational Expectations Hypothesis, Muth did not think of it as a normative hypothesis that individuals were omniscient or that they all thought alike. He also did not claim that the hypothesis presumes that every market participant must forecast according to the relevant economic theory: the Rational Expectations Hypothesis “does not assert that the scratch work of entrepreneurs resembles the system of equations [in an economist’s model] in any way” (Muth, 1961, p. 317). Moreover, it does not imply “that predictions of [individuals] are perfect or that their expectations are all the same” (Muth, 1961, p. 317).


    • 5 Castles in the Air: The Efficient Market Hypothesis
      (pp. 81-102)

      THE THEORY OF the rational market arose as an attempt to provide a scientific underpinning to the Efficient Market Hypothesis, which serves as the cornerstone of financial economics. According to the hypothesis, asset “prices always ‘fully reflect’ available information” (Fama, 1970, p. 383).

      As it stands, the Efficient Market Hypothesis says very little about how prices unfold over time, or whether markets allocate capital well. There is an abundance of publicly available information about economic, political, and social factors and events that is quickly disseminated to individuals around the world. Participants select from this flow of information when forming their...

    • 6 The Fable of Price Swings as Bubbles
      (pp. 103-114)

      THE GLOBAL FINANCIAL CRISIS that began in 2007 has led many observers to question the relevance of contemporary macroeconomic and finance theory for understanding outcomes and guiding policy. Many economists have also recognized that their portrayals of individual behavior and markets are deficient. But they have remained steadfast in their belief that they should continue to search for better, and even more complete, fully predetermined accounts of outcomes.ₑ

      To be sure, swings in housing, equity, and other markets, which are often blamed for the crisis, substantially eroded faith in the ability of financial markets populated by rational participants to allocate...

    • 7 Keynes and Fundamentals
      (pp. 117-148)

      THE RUN-UPS IN housing, equity, and other asset markets and the subsequent sharp reversals that were among the proximate causes of the financial crisis that began in 2007 solidified the belief that asset-price swings are largely unrelated to fundamental considerations. Instead, price bubbles supposedly form and collapse as a result of the trading decisions of market participants who are irrational, prone to emotions and other psychological factors, or engage in momentum trading.

      Many observers point to the long upswing in U.S. equity prices during the 1990s as a prime example of such behavior and widely refer to this upswing as...

    • 8 Speculation and the Allocative Performance of Financial Markets
      (pp. 149-162)

      FINANCIAL MARKETS provide assessments of the relative prospects of companies’ assets. They set prices to reflect the stream of expected future returns on past investments, as well as that of new investment projects for which financing is being sought. Markets allocate capital based on these price signals: the higher the price of a company’s assets, the easier it is for it to attract financial capital, whereas lower prices make financing more difficult. For markets to perform this allocative function well, participants’ decisions to, say, buy and sell shares of particular companies should reflect changes in the relative prospects of companies...

    • 9 Fundamentals and Psychology in Price Swings
      (pp. 163-174)

      BLOOMBERG’S MARKET WRAP reports indicate that short-term movements in a wide array of fundamental factors—from corporate earnings to the price of oil—underpin participants’ trading decisions in equity and other asset markets. Participants interpret the impact of movements of fundamentals on the prospects and returns of companies over the near and longer term, causing their relative prices and thus their access to financial capital to change. As this allocative process unfolds over time, individual stock prices and broad price indexes also tend to undergo swings of unequal magnitude and duration away from and toward estimates of common benchmark levels....

    • 10 Bounded Instability: Linking Risk and Asset-Price Swings
      (pp. 175-194)

      WE HAVE DISCUSSED how trends in fundamentals and guardedly moderate revisions of participants’ forecasting strategies, and the contingency of such qualitative characterizations of change can account for the price swings observed in asset markets. We also sketched how swings in broad price indexes arise from movements in the relative prices of assets. In this chapter, we explain how these swings play an indispensable role in the process by which financial markets allocate capital to alternative projects and companies. However, we also show why, owing to imperfect knowledge, price swings can sometimes become excessive: prices move beyond a range of values...

    • 11 Contingency and Markets
      (pp. 195-216)

      ACCORDING TO OUR IKE model, prices and risk tend to undergo swings when trends in fundamentals persist for some time, which they do quite often, and market participants have no specific reasons to expect a change, and thus they are likely to revise their forecasting strategies in guardedly moderate ways. We would expect, therefore, that fundamental factors play an important role in driving asset-price swings and risk. We would also expect the set of fundamental factors and their influences to change over time.

      Yet nearly all of the literally thousands of empirical studies make no allowance for any change in...

    • 12 Restoring the Market-State Balance
      (pp. 217-248)

      IN MUCH-TALKED-ABOUT testimony before the U.S. Congress in October 2008, former Federal Reserve Chairman Alan Greenspan revealed his “shocked disbelief” that market participants’ self-interest had failed so spectacularly in “protecting” society from the financial system’s gross excesses, culminating in the worst crisis since the Great Depression.ₑ Greenspan went on to acknowledge that he had “found a flaw” in the ideology that unfettered financial markets would limit their own excesses.

      Although the crisis that started in 2007 has vividly exposed the dangers inherent in relying on financial markets to self-regulate, policy reforms adopted around the world have largely excluded measures requiring...

  7. Epilogue
    (pp. 249-256)

    Market outcomes (such as asset prices) or overall levels of economic activity, consumption, or investment result from the decisions of many individuals. In analyzing how outcomes unfold over time, Hayek, Knight, Keynes, and other early modern economists related their accounts to individual decisionmaking. Their profound insight was to place nonroutine change and market participants’ imperfect knowledge at the center of economic analysis. This focus led them to discover the limits of economists’ownknowledge—and thus of economics itself.

    Knight’s arguments concerning the importance of “radical uncertainty” led him to question the relevance of standard probability theory for understanding profit-...

  8. References
    (pp. 257-272)
  9. Index
    (pp. 273-285)