Shocking Alan Greenspan

Earlier this month, a bipartisan Senate subcommittee concluded that the financial crisis “was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.”  The subcommittee was hardly staking out new ground.  An emerging consensus holds that self-interested bankers, mortgage brokers, and other players took advantage of weak or broken regulations to profit at the expense of investors, homeowners, and the larger society.  Indeed, some commentators have begun to wonder why no one has yet been indicted.

In the Myth of the Rational Market, Justin Fox tells a different story.  He leaves to others most of the reporting on too-big-to-fail financial institutions, mortgage-backed securities, and other so-called weapons of mass financial destruction.  For him, the financial crisis is of particular interest because it represents the final dismantling of the idea of the rational market.  In the aftermath of disastrously leveraged and complex financial products that seem to have been premised on the notion that real estate prices can only go up, few would still claim that markets always know best.

Yet, the idea of a rational market is far from a straw man, and Fox’s main contribution is to describe in accessible terms how the idea developed, how it was championed, and how its defenders have addressed or ignored a variety of criticisms and contradictory evidence.  Fox begins with a vignette that highlights his thesis:  former Federal Reserve Chairman Alan Greenspan’s remarkable admission that he was wrong to believe that markets are reliably self-correcting.  In testimony before the House Committee on Government Oversight and Reform, Greenspan stated that when the markets crashed, he was “shocked” and that the “whole intellectual edifice collapsed.”  In Fox’s pithy summary, Greenspan conceded “[t]hat he had misunderstood how the world works.”  

Greenspan's testimony is the stuff of a Tom Stoppard play:  an intellectual brought low by the ugly realization that his elegant theories can't be reconciled with our perpetually inelegant reality.  If Stoppard needs a new subject to tackle, Fox's book belongs at the top of his reading list.  It is a credit to Fox’s account that he presents ideas fairly and in context so that it is possible to appreciate the basis for Greenspan’s faith in the rational market as well as its shortcomings.

At times, though, Fox is almost too evenhanded.  In a follow-up post, I will point out some potential ambiguities in Fox’s analysis of what the rational market is and what it does.