Just How Mythical Is the Rational Market?

 

The Myth of the Rational Market has lots and lots of people in it, and it's not as polemical as the title makes it sound. These observations came up repeatedly in yesterday's posts—which I found very interesting because they both reflected choices I made early in the process of writing the book. Same goes for David Zaring's question: "Should You Be Assigning the Myth of the Rational Market To Your Class?" (Note from my wife, a law school grad: yes yes yes yes!) 

Myth was not a financial crisis book. If I had turned the manuscript in on time, it would have been published in 2005. Back then, I figured that getting mainstream attention for the book was a long shot, so I needed to write it in a way that would appeal to professors at business schools, law schools, and elsewhere who might assign to their student. I figured that meant (1) not paring the cast of characters down as much as I would have if optimizing narrative flow had been my only concern and (2) not calling people idiots.

I still did leave lots of interesting and important scholars by the wayside. The omission that continues to bother me the most is probably MIT's Andy Lo. He's been one of the most nuanced and constructive critics of the efficient market worldview, and in early drafts of the book he played a significant role. As I pared things down, though, his story mostly disappeared. Then there's the stuff that I just plain missed, like the 1977 Edward M. Miller paper that Lynn Stout discusses. But the goal was to have most of the major papers and scholars that someone in the field should know about represented in the book, rather than just picking four or five people to focus on.

As for my studied neutrality, I wasn't that neutral. Gene Fama feels pretty strongly that I painted him as the villain, while Dick Thaler, Andrei Shleifer, and Larry Summers seem happy enough about how the book turned out. (I'm still not sure whether Bob Shiller, another major figure in my narrative, is aware that the book exists). But yeah, I wanted people on both sides of the rational-market divide to be able to read the book and find it useful.

So what do I think about the efficient market hypothesis? That in certain contexts it's really smart and useful, and in others it's silly and dangerous. Second-guessing the judgments of financial markets is not something to be done lightly, and most of the time most of us are better off not trying to. But that's different from saying that financial markets are always right, and will always steer economies optimally as long as they are freed from government interference. The first claim is one of modesty, the second of hubris. Yet both have been made and continue to be made under the banner of the efficient market.