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Friday, August 07, 2009

"School for Scoundrels"

Paul Krugman reviews Justin Fox’s “Myth of the Rational Market”:

School for Scoundrels, Book Review by Paul Krugman: Last October, Alan Greenspan — who had spent years assuring investors that all was well with the American financial system — declared himself to be in a state of “shocked disbelief.” After all, the best and brightest had assured him our financial system was sound: “In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. . . . The whole intellectual edifice, however, collapsed in the summer of last year.”

Justin Fox’s “Myth of the Rational Market” brilliantly tells the story of how that edifice was built — and why so few were willing to acknowledge that it was a house built on sand. ...

Instead of focusing on the errors and abuses of the bankers, Fox ... tells the story of the professors who enabled those abuses under the banner of the financial theory known as the efficient-market hypothesis. ... Wall Street bought the ideas of the efficient-market theorists, in many cases literally: professors were lavishly paid to design complex financial strategies. And these strategies played a crucial role in the catastrophe that has now overtaken the world economy. ...

One of the great things about Fox’s writing is that he brings to it a real understanding of the sociology of the academic world. Above all, he gets the way in which one’s career, reputation, even sense of self-worth can end up being defined by a particular intellectual approach, so that supporters of the approach start to resemble fervent political activists — or members of a cult. In the case of finance theory, it happened especially fast...

In this sense, efficient-market acolytes were like any other academic movement. But unlike, say, deconstructionist literary theorists, finance professors had an enormous impact on the business world — and, not incidentally, some of them made a lot of money in the process. ...

I came away ... wondering if [the] underlying premise — that the current crisis will put an end to Panglossian views of financial markets — is right. Fox points out that academic belief in the perfection of financial markets survived the 1987 stock market crash and the bursting of the Internet bubble. Why should the reaction to the latest catastrophe be any different? In fact, what I hear from my finance professor friends is that there’s a lot less soul-searching under way than you might expect. And Wall Street’s appetite for complex strategies that sound clever — and can be sold to credulous investors — survived L.T.C.M.’s debacle; why can’t it survive this crisis, too?

My guess is that the myth of the rational market — a myth that is beautiful, comforting and, above all, lucrative — isn’t going away anytime soon.

    Posted by on Friday, August 7, 2009 at 05:25 PM in Economics | Permalink  Comments (40)


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