Four decades ago, a Chicago economist named Eugene Fama proclaimed that financial markets are efficient. The march of this thesis from the fringe to the mainstream is one of reason’s sweetest triumphs. Despite periodic bouts of wantonly irrational investor behavior, most people now accept that financial markets—indeed, all markets in which people trade views about the future—are the least bad way of processing information. Today, markets are used to predict everything from influenza outbreaks to the sales of a new Harry Potter book.
To see how complete this triumph has become, consider the reaction to last week’s financial turmoil.
What happened last week—and what may continue this week, too—was that the “Davos divide” between economic and political thinkers began, at last, to narrow. Until last Monday, financiers appeared blissfully carefree: They demanded minuscule premiums to lend to risky borrowers, and the gusher of cheap loans was propping up global growth, fueling blockbuster private-equity deals and brewing an aimless malaise among the crisis fighters at the International Monetary Fund. The business leaders who assembled at the Davos summit in January were in an ebullient mood—despite the scary news from Iraq and Iran and despite America’s diminished capacity to underpin global security.
That was, until Monday. But then, on a dime, market sentiment reversed itself. On Tuesday the Standard & Poor’s 500 index suffered its biggest one-day fall in almost four years, ending its longest run without a 2 percent drop since the 1950s. Stock market volatility, which had been eerily low, jumped by more than 60 percent. Calm turned into chaos.
This kind of about-face is exactly what emboldens skeptics of the efficient-market theory. If prices are “efficient,” there should be no abrupt U-turns: “Efficient” means that all information is reflected in prices; you should get moves only in response to new information. But no stunning news explained last week’s jump in volatility. Alan Greenspan gave an anxious speech, but anyone with half an eye on mortgage defaults should have felt anxious already. China’s stocks fell, but a small market that largely excludes foreigners need not have spooked investors in London or New York.
The truth is that market sentiment shifted for no satisfying reason. One day investors made light of storm clouds; the next day they yelled in terror. But the remarkable thing is that, despite this capricious behavior, no denunciations of markets or speculators emanated from Congress. Sen. Chuck Grassley (R-Iowa), who had recently growled about the secrecy of hedge funds, was not moved to say anything. Democrats, who might have been expected to condemn (again) the idea of putting Social Security money in the stock market, stayed silent.
This was all good, but it was not all predictable. In most eras and in most countries, bouts of market chaos provoke outbursts of market skepticism. During the 1997 emerging market crisis, Malaysia’s leaders called George Soros a “moron” and said speculators should be caned. Germany’s deputy chancellor has described hedge funds as locusts, and Nicolas Sarkozy, the supposedly pro-market French presidential aspirant, recently questioned whether they are ethical. Here in the United States, Rep. Dennis Hastert (R-Ill.) once railed against the “blatant thuggery” of investors who bet on stocks’ decline.
These outbursts are not surprising because markets are efficient and irrational at the same time. They process information well enough that second-guessing them is extremely difficult, but sometimes they assign values that make absolutely no sense. At one point, Palm, a maker of personal digital assistants, had a larger capitalization than the computer company 3Com. But this was mathematically absurd: 3Com owned 95 percent of Palm’s shares.
If politicians have ample excuses to take shots at markets, why the restraint after last week’s chaos? It would be nice to believe that members of Congress grasp the intricacies of Wall Street: During the recent turbulence, the purest apostles of market forces (hedge funds) sensibly drove up risk premiums, while stodgier bits of the system (credit rating agencies, government-backed mortgage lenders) had their heads in the sand. But it’s unlikely that such detail figures into politicians’ calculations. Rather, respect for the efficiency of markets reflects a shift in the culture.
A long time ago, in a more aristocratic era, Henry David Thoreau lamented that “the mass never comes up to the standard of its best member.” But in the age of the Internet, people are more inclined to believe that the decentralized efforts of large groups can be better than the work of experts. Wikipedia has edged out traditional encyclopedias; eBay can value your car better than a local used-car dealer. And politicians have a special reason to respect the wisdom of markets. Amateur traders on the University of Iowa’s political futures market predict elections more accurately than professional pollsters.
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