The Economy of the World Is Not Run by Robots
When I went to business school, we learned the Efficient Market Hypothesis, which had been developed in part by Eugene Fama. Fama won the Nobel prize in economics in 2013. I actually met him once in the 90s—I am friends with his son, also named Gene, who was a Los Angeles cartoonist I had worked with. I was in town job hunting at BookExpo . We had dinner at Fama’s house and I was put on my back foot when Fama pere asked penetrating questions about why I was in town (he was appropriately skeptical of this method of job hunting).
But by the time he won the prize, his theory had been in essence debunked. To grossly oversimplify, EMH suggests that for any traded item (like a share of stock), the market settles on the real price very quickly, because any mispricing by any actor (buyer or seller) is quickly counter-acted by someone who knows that their counterpart is wrong. This was a big fad in the 80s and 90s when investors were trying to use arbitrage to exploit small mispricings. It was a failed arbitrage play that caused Long-Term Capital Management to lose $3.6 billion in 1998. one of the biggest failures of EMH before the subprime mortgage crisis in 2008. Alan Greenspan called the dot com bubble of the 90s as an example of “irrational exuberance.” EMH is supposed to be a brake on manias and crazes like these. This theory failed massively in the real world.
It failed because despite traders being mostly rational beings, human psychology still plays a part. This was Daniel Kahneman’s insight. which was called Prospect Theory, won him a Nobel prize in economics in 2002. He was a psychologist, not an economist. He was the father of behavioral economics. Prospect Theory’s main insight was relatively simple—people value losses and gains differently. Let’s say you are flipping a coin and betting on the outcome. If it’s heads, you win a dollar and if it’s tails you lose a dollar. While of course you want to win, if you were an emotionless EMH robot, you would be indifferent to the outcome. But people have loss aversion. They don’t make choices like robots.
We studied a little behavioral economics in B-school. When I was in school, the subprime mortgage crisis was just beginning—people were trying to explain what happened with Bear Stearns. Clearly a whole firm of really smart, rational, price-seeking traders all guessed wrong.
The math of EMH is unimpeachable. But Daniel Kahneman proved it doesn’t work in the real world and therefore as long as we continue to live in a capitalist economy, there will be financial crashes. I’ve often thought that Fama got his Nobel as kind of a consolation prize for coming up with a beauitful (if wrong) theory.
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