Macroeconomists seemingly have adopted monastic practices of self-flagellation to explain why the tribe completely misjudged the housing bubble . Their collective crystal balls didn’t predict an ensuing financial crisis either. A blog entry by Finance Professor Raghu Rajan at University of Chicago has further stimulated the conversation today. He’s written a book called Fault Lines and made remarks from the book at its official blog site. I found it at Memeorandum along with a few choice links.
I’ve written about fresh water and salt water economics before. Some of today’s discussion clearly involves philosophical fault lines. Rajan is from the panultimate fresh water university and all finance academics eventually drown in the Efficient Markets Hypothesis (EMH) literature. I’ve been pretty outspoken about how much damage I think the EMH has done to economics and especially my field, financial economics. However, it’s hard to get published in finance journals taking a contrarian view. This is one explanation he examines, then dismisses which is why I’ve taken a good look at his argument.
I have not read his book, but judging from the video and this blog entry, Rajan spends some time on the role of EMH and EMH true believers in the crisis. I can provide you with my own anecdotes on this. I can also tell you I tried to avoid some seminars because I don’t want to read any more Eugene Fama who is Rajan’s colleague. I frankly think EMH blinders or misunderstanding were a good deal–but not all–of the problem.
I was researching the subprime markets directly after Katrina and was told by my finance professors that I was following an unpublishable and boring line of research. (They used the term ‘unsexy’.) I saw hints of problems in subprime markets as early as late 2005 in the work I did with the sensitivity of stock prices of finance companies heavily invested in subprime loans to some key macroeconomic variables. I was told that line of research was unlikely to help my marketability and ability to get tenure upon graduation. They yawned when I presented the paper. I turned it in for my third econometrics seminar and switched to something else.
Finance journals editors do love them some EMH so anything on market anomalies is likely to get a jaundiced set of editor eyes. But, Rajan brings up some important points and the resulting discussion is worth viewing here. Here’s Rajan talking directly to the EMH and why he thinks it may not be a big deal.
Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.
Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) simply ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.
Rajan points out that this probably isn’t the sole or primary explanation even though it is one that gets a lot of ink these days. I too think some of the problem is a misunderstanding of the various forms of EMH . So, the major philosophical debate happening in finance circles isn’t central to Rajan’s explanation. There is no conspiracy of EMH apologists to force misunderstanding of market rationality, so alright, I’ll give him that one.
Economist Tyler Cowen at Marginal Revolution likes the alternative succinct explanation Rajan provides. (You should read the comments to that thread.)
Raghu Rajan nails it:
I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.
Rajan also dismisses another circle of conspirators by stating this. It’s also probably why one of those so-called progressives jumped on the dismissal earlier today. This conspiracy meme crosses circles of folks that are more into political economy than economics itself. This group argues the hypothesis that the “system” bribed economists to stay quiet. I’ve gotten into it more than a few people of the Matt Stoller mindset and various Rand hanger-ons about this improbable case. One of the biggest memes is that the FED actively influences economists not to publish things against their interests. (Usually, this comes from Austrian School folks who can’t get published any where mainstream because they want to completely operate outside of the scientific method and ignore data.) Matt Yglesias is one of these people making a living off this canard and he jumped to the bait immediately. His reasoning speaks more about him than about economists.