Are Markets Rational?

Are Markets Rational? Two Historians' Perspective on the Global Financial Crisis

A 2005 article in McKinsey Quarterly asks whether fundamentals or emotions drive the stock market, and comes down squarely on the side of fundamentals. Given the dramatic upheavals that we have witnessed in recent years, it is hard for a layperson to understand the authors' conclusion that the price of a stock consistently reflects its actual value. Seeking to understand the rationality of the market and to put the recent financial crisis into perspective, we engaged two respected professionals: Richard Sylla, Henry Kaufman Professor of The History of Financial Institutions and Markets and Professor of Economics at the Leonard N. Stern School of Business, New York University and George David Smith, Clinical Professor of Economics and International Business, New York University.

George Smith made it clear that to him the question of whether markets are rational is not particularly useful. What is more important to a historian, he states, is why people believe that the market is rational and how that belief affects their actions. "Without buying into an ideology, our job is not to justify or follow a theory, but follow the facts, which are usually more complex. If you start with a theory, it narrows the questions you can ask." In the case of something as large and complex as the recent financial crisis, a clear historian's view may help us begin to understand.

As any economist can tell you, a market is a process; people are selling, people are buying and, in a perfect world, everyone is happy. For all of its occasional volatility, the stock market serves a real function in the economy. It exists to allow companies to raise capital--capital they can use to expand, experiment and create.

When a person buys a stock they are betting on a future dividend. If they believe that the current stock price is lower than the value of that future dividend, they should buy; if they believe that the price is higher than that future value, they should sell. The problem is that we can only make a best guess as to that future value. Being humans, we tend to be influenced by our circumstances and by the opinions of others. For better or worse, as Richard Sylla says, "Things like the stock market are reflections of human nature."

When someone invests in the market, whether they are a professional trader or a regular joe with an online account, they are subject to human failings. Investment decisions may be based on research or hype. People follow trends. Even those who know that a stock is overpriced may buy if they believe that the price will rise short term, thus those who profit from a bubble. Thus, making a decision based on a solid projection of future revenue may not always be the most profitable plan, especially in the short term. But knowing when to get out requires predicting human behavior. As Sylla recounts, even one of the smartest people in history, Sir Isaac Newton, fell victim to the south sea bubble in the 1720s. How then can any of us expect to do better?

Historically, the market is subject to alternate waves of optimism and pessimism. If most people are optimistic about the future, then stocks can become overpriced, and if they are pessimistic, stocks can become underpriced. The optimism spurred by general economic growth and belief in the bright future of technology led to the overpriced dot-com bubble of the late 1990s. The high inflation and high interest rates of the 1970s engendered pessimism that led to stock being underpriced for a time. In each case, the market has eventually moved back in the other direction.

Economic theories abound. Economists love to create theories that explain everything in neat, mathematically-sound ways. In his book, How Markets Fail: The Logic of Economic Calamities, John Cassidy describes some of these seductive theories. One that has influenced U.S. policymakers is Robert Lucas' rational expectations hypothesis, which holds that every investor understands the economy and will make rational decisions. This efficient market theory matters to us because it has influenced economic policymakers to favor increasing deregulation. After all, if we can count on the market to be efficient, any government intervention can only make things worse.

At its worst, economic theory can result in circular reasoning. The price of a stock is correct because it's the price. Markets are efficient because they're efficient. As Smith states, "Economic theory is nothing more than a hypothesis that has been mathematically tested, but is still open to challenge." Of course, there are a wide variety of economic theories. As the authors of the McKinsey article pointed out, even before the most recent market bust, "A number of finance scholars and practitioners have argued that stock markets are not efficient--that it, that they don't necessarily reflect economic fundamentals."

Smith argued that a certain amount of market turmoil can be useful to society. The dot-com bubble lost money for many investors, but it also helped to fuel a whole raft of innovations. While many new businesses failed, those that survived have created entirely new business models. The problem with the financial crisis of 2007-2008 is that, unlike the dot-com bubble, it wasn't based on anything new.

So what made this most recent stock market crisis so devastating? After all, as Sylla points out, the dot-com bust resulted in a similar monetary loss in the stock market, but didn't have the same broad effect on the larger economy. In this case, it began when low interest rates and home ownership subsidies encouraged bad mortgage loans. A combination of unreasonable optimism and unscrupulousness meant that many consumers took out mortgages that they were unable to pay for long term, based on the prevailing assumption that home prices would never go down. As history shows, home prices do fall, and they did so precipitously in 2007-2008. As Sylla states, "The idea that home prices couldn't go down is basically a convenient untruth."

Even a dramatic fall in home prices might not have had as broad an effect had not banks and other financial institutions extended themselves in new and foolhardy ways. Not only did they back unstable mortgages, but they bundled mortgage-backed securities and sold them as solid investments. Meanwhile, the same low interest rates that pushed the mortgage boom encouraged a dramatic rise in all types of indebtedness. As Cassidy points out, "Between the end of 2002 and the end of 2006, the total amount of debt outstanding the United States went from $31.84 trillion to $45.32 trillion, an increase of 42.3 percent." In different ways, across the globe, everyone from individual consumers to European governments were borrowing more than they could reasonably afford. There was a worldwide party, during which, let us not forget, some people made money hand over fist. But, like so many parties, it led to a nasty hangover. And this hangover spread its ill effects even to those who don't invest in the market.

There is plenty of blame to go around. Mortgage brokers shouldn't have sold mortgages that they knew consumers couldn't afford. Consumers shouldn't have bought more than they could afford. The Federal Reserve shouldn't have held interest rates so low for so long, even as the boom developed. The Securities and Exchange Commission and other regulatory agencies shouldn't have trusted in the market so much that they abandoned regulations that could have lessened the impact of the crisis. And, when the effects began to be felt, the government should have moved quickly to fund infrastructure programs that would have aided the economy and employed workers who had lost their jobs. In each case, the problem was at least as much a failure of human imagination as poor information. People, as groups and individuals, acted in ways that were inarguably irrational for the health of the economy as a whole.