Wall Street & Markets

Are finance professors to blame for the financial crisis (part 3)?

By Justin Fox | November 30, 2009 | +

Philip Coggan, a.k.a. The Economist‘s Buttonwood columnist, steers me to

a strange piece in the Financial Times today which attacks (without naming) Justin Fox’s book The Myth of the Rational Market.

The column is basically a rehash of a blog post by Gene Fama, which I addressed here a couple of weeks ago. And it doesn’t exactly attack my book:

I have explained in the past why it is odd to blame efficient markets theory for the malaise (basically, no one in the markets operates under its dictates; those who provoked the meltdown were not abiding by the construct, or even aware of its existence).

But the oddness goes beyond fingerpointing a creed that is clearly not followed out there. The author of the book does not blame the theory, which was rejected by the academic community decades ago. We now know that even the creator of the theory thinks it nuts to posit that his mathematical baby was the culprit, for the simple reason that it was never wholeheartedly adopted by professionals.

As Coggan points out, this misses the main thrust of those who argue that efficient market theory was in some sense responsible for the crisis. They’re saying that regulators and central bankers missed the many warnings signs of a bubble because they believed markets were efficient. And then there’s Robert Waldmann’s excellent corollary:

I think active traders have a schizophrenic attitude towards the efficient markets hypothesis. Obviously they fundamentally don’t accept it, yet they assume it is valid when designing hedging strategies or justifying their compensation schemes. It was switched off and on. The belief that comovements of CDS prices revealed the (assumed to be constant) correlation of latent variables which determined defaults (the Gaussian copula) was critical to the crisis. That belief relied on the EMH.

The author of the FT piece addresses neither of these issues in his essay. But that’s not my main problem with it. It’s that’s in the course of a 692-word piece that is largely about my book, he never mentions my name or the title of the book. Who would do such a thing? I mean, seriously, who?

(I actually bought the guy lunch a couple years ago, at a really nice restaurant. Maybe he got food poisoning or something.)

Related Topics: Economy & Policy, Wall Street & Markets

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  • http://www.alphaadder.blogspot.com bklapetzky

    That brought a smile to my face. Funny. Thank you.

    A (good) new piece related to all of this is “Macroeconomics and the Crisis: A Personal Appraisal by Axel Leijunhufvud UCLA and University of Trento

    Centre for Economic Research Policy Insight No.41

    Axel Leijonhufvud argues that theories that assume that the economy is a stable general equilibrium system, albeit beset with some frictions and imperfections, do not hold true in general and that we need a new paradigm of economic thought.

    http://www.cepr.org/pubs/PolicyInsights/CEPR_Policy_Insight_041.asp
    or with a little work
    http://www.cepr.org/default_static.htm

    Mr. Waldmann, if you are reading, AngryBear is outstanding. Incredible insight there. Thanks.

    Bob Klapetzky
    http://www.alphaadder.blogspot.

  • braktalk88

    Just in case you missed this: Poe’s Bon-Bon.

    WELCOME TO THE PARTY !!!

  • randymiller

    Stand your ground Justin. I read the FT piece, and he totally missed the point you were trying to make.

    He had a pre conceived notion, then shaped his arguments accordingly.

    IF I had a dollar for every time a politician, policy maker, or talking head said that 2008 was simply the markets working, in both financials and commodities….. when the fact was that psychology and herd mentality were driving prices. EMH and a lot of other economic theories are used to keep the sensible people at bay. Everytime a sensible person questions the movements of the markets, the powers that be just use theory as a stick to convince the sensible that they are not smart enough or educated enough to understand how the markets really work.

    If engineering schools taught a bunch of theories that did not work, they would not be open for very long.

  • jymallyn

    “Free markets” ONLY work when the market is free. When the folks who benfit from the rules, determine what the rules are, then the market is NOT free.

    Willie Sutton robbed banks because the money was there. His grandchildren went to Harvard and now OWN the banks.

    How many grandchildren of Mafia members now have MBA’s?

    And for the benefit of “fundamentalists” this is another example of “Evolution.”

    What our Constitution is supposed to guarantee is “honest weights and measures.” It is also why some of the Lehman Brothers and BearSterns executives probably need jail time.

    And some of the folks at the CIA and State Department (as well as Karl Rove) likely deserve jail time at Gitmo as “Enemies of the State.”

  • http://jingleyanqui.wordpress.com Jingle

    it is too complicated to blame any single person, organization, or the president, nobody really knows what’s really happening, read things you assume that you may not like it will shape your thoughts and put you in moderate position, though.

    good luck blogging!

  • http://www.alphaadder.blogspot.com bklapetzky

    Well said, Mr. Miller.

    Bob Klapetzky
    http://www.alphaadder.blogspot.com

  • determinista00

    It’s funny that he wrote the following back in June in a column titled “B-School Professors, Not Students, Are to Blame”:

    It’s the theories concocted and sponsored by the theory-adoring professors that can cause the real troubles, and that did cause trouble this time and in the past. Theoretical concoctions played a decisive role in the unleashing of the current crisis, as they have, by the way, in all the worst market disasters since 1929. B-schools, by churning out, promoting, and endorsing the theoretical method (over any other considerations) are responsible. By endowing the use of (often deleterious, almost always flawed) analytical tools with untold respectability and legitimacy, the current b-school status quo puts us all in danger. That’s the truly unseemly and unjustified behavior, not MBAs behaving (for better or worse) as businesspeople.

  • http://mph41.wordpress.com mph41

    That’s a good catch deterministaoo, Triana does seem to be blaming theories and models, many of which are predicated on EMH.

    Also what I find interesting is that Triana goes out of the way to quote Taleb, whom also wrote the foreword to his book, in the FT column. According to the pull-quote on the back-cover of “The Myth of the Rational Market” Taleb thinks Fox is an insightful guy. I really wish we could know Taleb’s reaction to that column.

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