Time to update Economic Theory 101
Some economists believe that economic models are dated and deficient, and they're looking for theories that would help make sense of the financial crisis and global economy. Janet Babin has more.
Man looks at "exploding" stock market board (Yoshikazu Tsuno/AFP/Getty Image)
More on The Economy, Wall Street, America's Financial Crisis
TEXT OF STORY
Kai Ryssdal: Today was another one of those days in the stock markets. Up a couple hundred points, then down a couple hundred points. Like it's nothing at all. In fact, except for the past couple of months, it's incredibly unusual. For decades now, longer actually, the theory was that free markets in equities and everything else are self-correcting. They act rationally. Now, though, economists are looking for new theories to help understand what's going on. Janet Babin reports from the Marketplace Innovations Desk at North Carolina Public Radio.
Janet Babin: Think back to Econ 101, you probably remember studying this guy: Milton Friedman. He had a theory about economics -- madly popular for the past 50-plus years. Professor Brad DeLong at the University of California, Berkeley, sums it up this way.
Brad DeLong: His theory was the market is always right.
And, that markets are rational. If a company posted good results, that should up its stock price. Bad results should have the opposite effect. The efficiency of the markets would take speculators out and reward responsible investors in the long haul. Problem is, the theory hasn't worked so well lately. Markets have gone rogue, hedge funds have blown up, large investment banks have become extinct and credit is beyond tight. DeLong says researchers are scrambling to find a solution.
DeLong: Why doesn't the magic of market weed these gamblers out of their high financial positions fast enough that we can trust these markets. And that I think is the important, open issue in economic theory and what everyone is trying to work on.
Frantically trying to work on. Economists are behind closed doors dissecting the financial crisis to create the next big theory. One that explains why the markets aren't rational. One idea getting attention is nearly the opposite of Milton Friedman's. It says that markets don't respond to outside events. Instead, they have their own internal, random dynamics. They're complex and non-linear. Yep, non-linear is where I started to get confused, too. But Duke Law and Business professor Steven Schwarcz explains "non-linear" pretty well.
Steven Schwarcz: Events that you think will have one response might have a very different response.
Take traffic patterns. An accident on one side of the road shouldn't cause a back up on the other side, but you know it always does. It's the same with markets. One little thing happens somewhere, oh I don't know, say, a relatively small percentage of sub prime mortgages blows up, and bam.
Schwarcz: You have market consequences that you would not expect in advance.
Like the collapse of the housing and credit markets and a global economic meltdown. So much for balance. When engineers tackle chaotic systems, they put backstops in place. A circuit breaker to stop a total blackout or emergency brakes to prevent a runaway train. Schwarcz has clamored for the same type of market safeguards for the past year. He urged the government to take a stake in troubled banks.
Schwarcz: I certainly feel that I've been crying in the wind and no one listens.
The more radical the theory, the harder it becomes to be heard. Andrew Lo, a still-successful hedge fund manager and MIT professor knows something about that. His concept is called the Adaptive Market Hypothesis. It holds that markets mirror human behavior that's often irrational. To research his theory, he strapped electrodes onto traders in simulated market sessions. He monitored their blood pressure, pulse and other responses. Lo says markets are efficient, so long as things stay calm. But during stressful times, like now, when people are panicked?
Andrew Lo: The emotional aspects dominate, and then you're going to see very strong reaction that will not correspond to the traditional models that we're used to applying to markets.
Lo's been using the new model at his hedge fund. Meanwhile, mainstream economists are still hard at work on their own theories, hoping to become the next Milton Friedman.
In Durham, North Carolina, I'm Janet Babin for Marketplace.
Comments
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From Logan, UT, 11/11/2008
I have used the Austrian / Misesian model in my own business and personal economic decisions. I have been able to dodge recent pitfalls and find great satisfaction in studying it.
I see no plausible reason why this theory would not work supremely well for economies of all scales, apart from the fact that it requires a level of intellectual discipline and rigor not found in mainstream economics.
11/11/2008
"Free" markets, rather than being rational and self-correcting, are in fact unsustainable and self-limiting. The forces operating the markets are blind fear/greed. When there is no more money to be made in a particular "free" market, it collapses, since making money was the sole reason for its existence. Our currency itself is manufactured in a "free market" production plant called the Federal Reserve Banking System, which issues debt (creates money). Since only the principal of, but not the interest on, that debt, is created, the very currency which propels all other "free" markets collapses in a credit crunch, which we are now experiencing. Activity in "free" markets is motivated by competition, amplified by fear/greed, for apparently scarce dollars. Markets will be truly free when people are freed of the fear/greed emotion. We should sincerely heed the advice conveniently printed on each dollar bill and trust in God.
11/11/2008
Ditto Dan Fallon. 'Twould seem that most economists -- and all statists, are intent on ignoring the Austrian elephant in the room.
The god of state will fail, however, and the Keynesian concubine has proven to be barren.
From RI, 11/11/2008
I echo some of the smart folks above that urge you to take a good look at the Austrian School. Although, failure to do so would be indicative of your marriage to statist positivism which, ironically, is also predicted by Austrian theory.
From Chicago, IL, 11/11/2008
Its amazing, really, how simple the answer to all of this is. Two words.
"Austrian Theory". These proponents of the Austrian Theory of Economics have been right time and time again. Yet, no one will listen. I think our future economic situation will force the American people to listen. Want a leg up in the soon to be mandatory national economic conversation? Read Mises and Rothbard. Check out the websites of Lew Rockwell and the Mises Institute. Point the finger where it belongs, at the central bank. Trust me, you'll be "FED" up.
11/11/2008
If a school of economics fails to predict an economically significant event then it is flawed. The only school of economics that predicted the current economic situation is the Austrian School. Why the inability to credit success and efficacy?
From TN, 11/11/2008
Want a new theory, try Austrian economics. It predicted this mess that Keynesian economics brought us into. If you want someone to explain it to you contact Ron Paul, or have a look at the Mises Institute: http://mises.org/
From Butler, KY, 11/11/2008
http://mises.org/story/3128
(The URL was stripped out of my previous post.)
From Butler, KY, 11/11/2008
How about the Austrian Theory of the Business Cycle?
I have found no more credible explanation of the recent economic downturn.
In fact, compared with the lunacy being advocated right now by leading economists (spend our way out of a recession caused by overspending?), the Austrian School is one of the few that even makes sense.
11/11/2008
Boy, talk about a massively flawed argument. Its like using the finest ingredients, but rotten eggs, and wondering why the cake never comes out right even though you insist you followed the directions. Free market assumes the consumer acts rationally because information costs are low. As we keep seeing, they aren't low at all--we get lied to about WMDs in Iraq, we are told there's regulation of lead paint on toys, and so forth. We the consumer can't make the educated decisions that would help a market, when we aren't educated. That's why Friedman keeps failing, its a great religious belief that has no grounding in reality. To wonder why a wrong theory never seems to work in reality, is like building on mud and wondering why no archetect can create a house that stands.
From new york, NY, 11/10/2008
you say the markets have failed. some will say that government has failed. milton friedman's theories are sound. its when politicians decide to interfere with the market do we create these boom and bust business cycles.
in the interview, you say:
"If a company posted good results, that should up its stock price. Bad results should have the opposite effect."
let the market take its course. why are bailing out these failed companies? let the market punish them. thats not going to happen because the politicians wont let it happen.
From new york, NY, 11/10/2008
you say the markets have failed. some will say that government has failed. milton friedman's theories are sound. its when politicians decide to interfere with the market do we create these boom and bust business cycles.
in the interview, you say:
"If a company posted good results, that should up its stock price. Bad results should have the opposite effect."
let the market take its course. why are bailing out these failed companies? let the market punish them. thats not going to happen because the politicians wont let it happen.
From Portland, OR, 11/10/2008
Here is an alternative economic view that may be worth reconsidering at this point -- "Political economy came into being as a natural result of the expansion of trade, and with its appearance elementary, unscientific huckstering was replaced by a developed system of licensed fraud, an entire science of enrichment." That's Karl Marx in 1844. So how about a story about how capitalism's internal contradictions are tearing it apart. Hmm, seems like we've been here before...
From News York, NY, 11/10/2008
RE: Time to update Economic Theory 101
Rarely have I heard such blather. Economics, like all other processes are human activities filled with self-serving, self-justified, duplicitous, generous, (etc.) actions.
Your economists should study cultural anthropology to understand how markets work & stop this blather about fundamentals, oh, how many angels dance on the head of a pin? - naive experts in search of a unifying theory indeed.
From Charlotte, NC, 11/10/2008
Markets aren't efficient? Markets have gone rogue? Oh, you mean the financial industry - one of the most highly regulated industries in the US? Or do you mean the housing market? The one that had congress and multiple presidents pressuring banks to take on risky loans? Or maybe you mean mortgage securitization, something invented by Freddie Mac when it was a government agency, distorting the market for liquidity for mortgage loans?
Oh yeah. It's the market that failed. These perverse results couldn't possibly come from the politicians and the government interfering with the market. Oh no, not that.
From Cincinnati, OH, 11/10/2008
Great story. I enjoyed it.
The topic of how irrationality affects markets is _the_ most important economics topic today. I understand the Friedman school and I'm pretty sure it holds true in the long term.
But we have other timescales to understand, and those have been given woefully short shrift among economists. Please keep an eye on this. Your story today discussed how it operates on time scales of a few minutes-to-a few months. Tell me about the medium term. Say 6-72 months. This is where it gets really interesting and important, and hasn't been handled properly at all.
You're on a good groove here, keep it going.
todd
From Boston, MA, 11/10/2008
For a fascinating explanation as to what is happening and what to do about it, I would love to hear Marketplace interview Stephen Zarlenga of the American Monetary Institute, or Ellen Brown, author of "Web of Debt", or the folks who created the MoneyMasters video. Along with others, they all hold that the 300 year-old fractional reserve banking system is ultimately unsustainable, must eventually collapse in just the kind of credit crunch we are seeing now. Fundamentally, they argue that fractional reserve banking requires ever increaing levels of debt, and the day must eventually come when debt can no longer be increased, and the system collapses in a crisis just like the present one. I have been looking for a convincing rebuttal to this thesis, have not been able to find one. For more, see http://whatsnotso.blogs.com/whatsnotso/2008/10/will-the-financial-crisis-change-the-game.html
From State college, PA, 11/10/2008
Here's a dirty trick: if somebody tells you markets are "nonlinear", ask them "But aren't nonlinear models just simplifications of infinite-dimensional linear models?" If they know what they are talking about, they'll say "yes" or "sort-of", in which case you are both left wondering why everybody keeps using the word "nonlinear" like it conveys some useful information when it doesn't.
"nonlinear" means "curved". The important followup is "How specifically is it nonlinear?"
Smart people have known Friedman has been wrong for a long time. The collapse described here is just an example of reality catching up with out-dated ideas.
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