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December 29, 2004

Markets Aren’t Rational.

Pootergeek notes a Financial Times article(it’ll go paid subscription only soon so go to his place and read quickly) showing that markets, especially financial ones, are not in fact rational. The Blognor Regis response is "No shit Sherlock" plus the sarcastic comment that what we really need is a wise person to determine all that messy business that we currently leave to such irrational markets.

As noted in the article there are indeed economists who insist that markets are rational (St. Milton amongst them of course) but this isn’t what I consider to be the error. (No, I’m not saying that Pootergeek is in error, he doesn’t explicitly state this position, just that this is a common error to my mind.) Whether markets are rational or not is less important than whether they are more or less rational than other methods of organising an economy. We’ve tried any number of alternatives, socialism, communism, theocracies, aristocracies, slave economies, centrally directed ones, corporatism, fascism (the last two are close twins) ....well, fill in your own ideas here.

What we’ve found is that, as in Churchill’s view of democracy, market based economies appear to be less bad than the alternatives. Resources get allocated more eficiently despite the predilictions  of markets to over-react. No, that isn’t the most ringing defense of the system I agree, but it is one that is observably true in an empirical sense. It also leads to a policy prescription. It is not enough to identify a malfunctioning market, or a market failure, and then call for action (usually by the State) to correct it. One also needs to loook at whether that action will make the problem of failure worse. For sad to say, we live in an imperfect world and there will always be problems, so let’s try not to make those we do identify worse eh?

December 29, 2004 in Economics | Permalink


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Markets are not rational in the short term but tend towards rational behaviour in the long term.

Irrational exuberance is a short term phenomenon

Posted by: EU Serf | Dec 29, 2004 3:43:25 PM

Based on the little reading I've done on it, I tend to agree with EU Serf. I think in a non-bubble market the Efficient Markets Hypothesis holds sway for most assets. I still think there are some assets that are undervalued by the herd, and that there is good empirical evidence to suggest that a lot of money can be made consistently by outing the value of these assets, particularly in the equities markets.

(The UK housing market is in a bubble no matter what anyone says; EMH does not apply here...Despite fetching, say, £220k from willing buyers, a three bedroom terraced house in Worthing is not intrinsically worth £220k: the bubble that caused that price is unsustainable...Luckily, though, when that bubble pops, people will still have assets, in their hands, unlike stocks in non-existent companies.)

The great historical fortunes have been made by people who bought low when no one saw the value in the assets they were buying.

And the market beats the hell out of centralised planning. All the little man has to do, though, is to make sure he doesn't get caught up in the exuberance, and to credit any money he makes in a bubble to being in the right place at the right time rather than superior financial nous (as most of the homeowning UK seems to be doing right now).

Posted by: James | Dec 31, 2004 9:41:16 AM

A couple of months ago Eugene Fama made news in a speech where he admitted that markets are not always efficient or rational. Naturally, the behaviorists jumped all over this. But his admission was hardly news (Excuse me, sir, would I be able to interest you in a tulip bulb?). And the behaviorists admitted they had most of their money in index funds.

Posted by: Joshua Sharf | Jan 10, 2005 12:57:51 PM