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The Irrational Market Theory

Late in life economist John Kenneth Galbraith addressed how he had been able to write so many books. He said he didn’t really produce that much that was new, he just waited until people made the same mistakes they always made and reworked his old material.

We can see that market based economies are dynamic systems; an economy is normally either growing or shrinking, but never static. This plays out as a regular cycle of booms and busts in the financial systems, which historically would quickly spread to the economy at large. Between 1865 and 1929, there were five major “Panics” (as they were called in the 19th century) each more dramatic than the last: 1873, 1884, 1893, 1907, and 1929. The last one of course lead to the Great Depression, which in turn lead to the New Deal government interventions into the financial markets.

Followers of the economist John Maynard Keynes (including Galbraith) credit government intervention with lessening the number and size of market crashes. But they have not eliminated them. And the debate over their causes and treatments might have been the single most important question in economics over the last hundred and fifty years.

Since Adam Smith economists have argued that markets are rational decision making machines, and that the best way to decide how scarce resources should be distributed is by letting an informed aggregation of individuals freely set the prices for goods and services. In some ways we can see this theory works well; Supply and demand curves normally can predict with some accuracy how much of a product will sell in a particular market at a particular price.

But to a careful observer the activities of markets at the macro level remain unpredictable. The aggregate worth of the companies listed on the Dow Jones stock exchange is not going to change by five percent in one business day, but that market has often moved by that much or more. Wikipedia lists more than forty occasions. And in fact between mid-September and mid-October of 2008 all three of the major U.S. stock exchanges lost between twenty and forty percent. The gross product of the economy as a whole may have declined during that period, but if so it was by less than a single percentage point.

We might simply say that the stock exchanges do not reflect the true worth of the listed companies, or of the economy as a whole. But if so, why not? The main reason a stock market exists is to rationally assign a market price to a public company and to let that firm use its worth to borrow capital.

Large rises or falls in an entire stock market require rash, and it could be argued irrational, actions by a large number of people at the same time. And over the last century economists have spent an enormous amount of blood, sweat and tears trying to explain why markets suddenly jolt in one direction or another.

One argument is that the brokers and investors are acting on incomplete or erroneous (or flat out falsified) information. The argument goes that when the truth is learned, the newly informed move quickly to adjust their position. But improvements in communications technology have not smoothed out the movements of the stock markets.

Another theory suggests that monopoly or oligopoly power cause problems by restraining free trade or the flow of information. But movements in the U.S. stock markets reflect the decisions of thousands, possibly millions, of people; arguments that a small group of individuals can consistently determine the direction the stock markets smacks of conspiracy theories.

We can’t underestimate the complexity and sophistication of the debates over these questions; a few lines here should not be mistaken for an encapsulation of decades of economics research. But in fact some studies suggest markets have an inherently irrational element (1), that even when all of the participants have equal power and are fully informed about what is happening, they still participate in bubbles and panics. This argument pushes economists uncomfortably into the realm of collective psychology and the behavior of crowds.

But this isn’t new territory for experienced stock followers. Many use mathematical models to try to predict market behavior, but others turn to psychological analysis. One axiom states simply that stock markets are driven by either of two emotions – greed or fear. Legendary investor Warren Buffet went so far as to say the secret to making money in a stock market is to be fearful when others are greedy and greedy when others are fearful. That philosophy is well enough recognized to have a name – contrarianism.

Questions about what causes speculative bubbles and crashes has not stopped people from effectively using market style mechanisms in all kinds of situations. This Wiki, for example, is based on the theory of Crowd sourcing – the idea that a group of people can effectively evaluate information when given the right opportunity. Which is a form of Collective Subjective action.

We could say that markets work in spite of not being totally rational.

Interestingly, this picture of markets and crowd sourcing resembles a longstanding argument about the nature of scientific fact. According to mathematician and philosopher of science Charles Sanders Peirce the scientific method does reach what we could call experimental truth, but not by any simple or automatic process. He argued that a theory may be proposed in an instance, but the value of it is arrived at only over time, as individual attempt to confirm or reject the assertion. All efforts to describe truth may be fallible, he said, and they have to undergo an experimental process that includes repeated attempts to confirm or deny them before what he called a fixation of belief takes place. He has been described as using the scientific method as a form of pragmatic epistemology.

As he put it in 1877, “few persons care to study logic, because everybody conceives himself to be proficient enough in the art of reasoning already. But I observe that this satisfaction is limited to one's own reasoning, and does not extend to that of other men.”(2)

(1) Smith, V., and Williams, A. Experimental market economics. Scientific American (December 1992), 116-121. (2) Charles S. Peirce. The Fixation of Belief. Popular Science Monthly 12 (November 1877), 1-15.

analysis/economics/irrational_markets.txt · Last modified: 2010/05/16 17:21 by ram