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Posted August 11, 2009

Books

Schools for Scoundrels

ILLUSTRATION BY SHOUT

LAST October, Alan Greenspan — who had spent years assuring investors that all was well with the American financial system — declared himself to be in a state of “shocked disbelief.” After all, the best and brightest had assured him our financial system was sound: “In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. . . . The whole intellectual edifice, however, collapsed in the summer of last year.”

THE MYTH OF THE

RATIONAL MARKET

A History of Risk,

Reward, and Delusion

by Wall Street. By

Justin Fox

By 382pp. Harper

Business/Harper Collins

Publishers. $27.99

Justin Fox’s “Myth of the Rational Market” brilliantly tells the story of how that edifice was built — and why so few were willing to acknowledge that it was a house built on sand.

Do we really need yet another book about the financial crisis? Yes, we do — because this one is different. Instead of focusing on the errors and abuses of the bankers, Fox, the business and economics columnist for Time magazine, tells the story of the professors who enabled those abuses under the banner of the financial theory known as the efficient-market hypothesis. Fox’s book is not an idle exercise in intellectual history, which makes it a must-read for anyone who wants to understand the mess we’re in. Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy.

This journey to disaster began with a beautiful idea. Until 1952, finance theory, such as it was, consisted of a set of wise observations and rules of thumb, without any overarching framework. But in that year Harry Markowitz, a graduate student at the University of Chicago, gave finance theory a new, hard-edged clarity by equating the concept of risk — previously a vague term for potential losses — with the mathematical concept of variance.

Markowitz’s model told investors what they should do, rather than predicting what they actually do. But by the mid-1960s other theorists had taken the next step, analyzing financial markets on the assumption that investors actually behaved the way Markowitz’s model said they should. The result was an intellectually elegant theory of stock prices — the so-called Capital Asset Pricing Model, or CAPM (pronounced “cap-em”). CAPM is a deeply seductive theory, and it’s hard to overemphasize how thoroughly it took over thinking about finance, not just in business schools but on Wall Street.

Markowitz would eventually share a Nobel in economic science with William Sharpe, who played a key role in developing CAPM, and Merton Miller, another central figure in the development of modern financial theory. Long before then, however, the innovative idea had hardened into a dogma.

One of the great things about Fox’s writing is that he brings to it a real understanding of the sociology of the academic world. Above all, he gets the way in which one’s career, reputation, even sense of self-worth can end up being defined by a particular intellectual approach, so that supporters of the approach start to resemble fervent political activists — or members of a cult.

In the case of finance theory, it happened especially fast: by the early 1960s Miller began a class at the University of Chicago’s business school by drawing a line down the middle of the blackboard. On one side he wrote M&M, for “Modigliani-Miller” — that is, the new, mathematicized, CAPM approach to finance. On the other he wrote T — for “Them,” meaning the old, informal approach. In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process.

This may seem strange, since CAPM and the broader work it inspired were based on the assumption that investors make mathematically optimal investment decisions with the information at their disposal. As a result, Eugene Fama, of Chicago’s business school, wrote, “actual market prices are, on the basis of all available information, best estimates of intrinsic values.” Fama called a market with this virtue an “efficient market” — and argued that the data showed that real-world financial markets are, in fact, efficient, or very nearly so. But if the markets are already getting it right, who needs finance professors?

In fact, however, Wall Street was eager to hire “rocket scientists,” especially after Fischer Black and Myron Scholes, working at M.I.T.’s Sloan School, came up with a formula that seemingly solved the puzzle of how to value options — contracts that give investors the right to buy or sell assets at predetermined prices. The quintessential collaboration between big money and academic superstars was the hedge fund Long-Term Capital Management, whose partners included Scholes and Robert Merton, with whom Scholes shared another finance Nobel. L.T.C.M. eventually imploded, nearly taking the world economy down with it. But efficient-markets theory retained its hold on financial thought.

All along, there were critical voices. Robert Shiller, who has become famous for predicting both the Internet crash and the housing bust, first made his mark by casting statistical doubt on the evidence for efficient markets. Lawrence Summers, now a senior official in the Obama administration, began a paper on financial markets thus: “THERE ARE IDIOTS. Look around.” And a whole counterculture emerged in the form of “behavioral finance,” which argued that investors are irrational in predictable ways. But the sheer scope and sweep of the efficient markets hypothesis — not to mention the fact that so many people devoted their careers to it — allowed it to brush off most of these challenges.

Of course, there have always been men of affairs wise enough to see past the current dogma. In “The Sages,” Charles R. Morris profiles three of them: George Soros, Warren Buffett and Paul Volcker.

Morris, the author of “The Trillion Dollar Meltdown,” doesn’t have much patience with economic theory, and it shows; I almost gave up on the book after Morris managed, in the space of just a few pages, to thoroughly misrepresent the ideas of both John Maynard Keynes and Milton Friedman. But the book comes to life with its personal profiles, especially the surprisingly endearing portrait of Warren Buffett as a young man.

Do the lives of the sages carry useful lessons for the rest of us? Soros doesn’t really seem to have a method, except that of being smarter than anyone else. Buffett does have a method — figure out what a company is really worth, and buy it if you can get it cheap — but it’s not a method that would work for anyone without his gifts. And Volcker’s main asset is his implacable integrity, which most mortals would find hard to match.

Indeed, I came away from reading these books wondering if their shared underlying premise — that the current crisis will put an end to Panglossian views of financial markets — is right. Fox points out that academic belief in the perfection of financial markets survived the 1987 stock market crash and the bursting of the Internet bubble. Why should the reaction to the latest catastrophe be any different? In fact, what I hear from my finance professor friends is that there’s a lot less soul-searching under way than you might expect. And Wall Street’s appetite for complex strategies that sound clever — and can be sold to credulous investors — survived L.T.C.M.’s debacle; why can’t it survive this crisis, too?

My guess is that the myth of the rational market — a myth that is beautiful, comforting and, above all, lucrative — isn’t going away anytime soon.

Paul Krugman, an Op-Ed columnist for The Times, is the author of “The Return of Depression Economics and the Crisis of 2008.”

Copyright 2009 The New York Times Company. Reprinted from The New York Times, Book Review, of Sunday, August 9, 2009.

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