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Time to update Economic Theory 101

Man looks at "exploding" stock market board

TEXT OF STORY

Kai Ryssdal:
Today was another one of those days in the stock markets. Up a couple hundred points, then down a couple hundred points. Like it's nothing at all. In fact, except for the past couple of months, it's incredibly unusual. For decades now, longer actually, the theory was that free markets in equities and everything else are self-correcting. They act rationally. Now, though, economists are looking for new theories to help understand what's going on. Janet Babin reports from the Marketplace Innovations Desk at North Carolina Public Radio.


Janet Babin:
Think back to Econ 101, you probably remember studying this guy:
Milton Friedman. He had a theory about economics -- madly popular for the past 50-plus years. Professor Brad DeLong at the University of California, Berkeley, sums it up this way.

Brad DeLong: His theory was the market is always right.

And, that markets are rational.
If a company posted good results, that should up its stock price. Bad results should have the opposite effect.
The efficiency of the markets would take speculators out and reward responsible investors in the long haul.
Problem is, the theory hasn't worked so well lately. Markets have gone rogue, hedge funds have blown up, large investment banks have become extinct and credit is beyond tight.
DeLong says researchers are scrambling to find a solution.

DeLong: Why doesn't the magic of market weed these gamblers out of their high financial positions fast enough that we can trust these markets. And that I think is the important, open issue in economic theory and what everyone is trying to work on.

Frantically trying to work on. Economists are behind closed doors dissecting the financial crisis to create the next big theory. One that explains why the markets aren't rational.
One idea getting attention is nearly the opposite of Milton Friedman's. It says that markets don't respond to outside events. Instead, they have their own internal, random dynamics.
They're complex and non-linear.
Yep, non-linear is where I started to get confused, too.
But Duke Law and Business professor Steven Schwarcz explains "non-linear" pretty well.

Steven Schwarcz: Events that you think will have one response might have a very different response.

Take traffic patterns. An accident on one side of the road shouldn't cause a back up on the other side, but you know it always does.
It's the same with markets. One little thing happens somewhere, oh I don't know, say, a relatively small percentage of sub prime mortgages blows up, and bam.

Schwarcz: You have market consequences that you would not expect in advance.

Like the collapse of the housing and credit markets and a global economic meltdown. So much for balance. When engineers tackle chaotic systems, they put backstops in place. A circuit breaker to stop a total blackout or emergency brakes to prevent a runaway train. Schwarcz has clamored for the same type of market safeguards for the past year. He urged the government to take a stake in troubled banks.

Schwarcz: I certainly feel that I've been crying in the wind and no one listens.

The more radical the theory, the harder it becomes to be heard.
Andrew Lo, a still-successful hedge fund manager and MIT professor knows something about that. His concept is called the Adaptive Market Hypothesis. It holds that markets mirror human behavior that's often irrational. To research his theory, he strapped electrodes onto traders in simulated market sessions. He monitored their blood pressure, pulse and other responses.
Lo says markets are efficient, so long as things stay calm. But during stressful times, like now, when people are panicked?

Andrew Lo: The emotional aspects dominate, and then you're going to see very strong reaction that will not correspond to the traditional models that we're used to applying to markets.

Lo's been using the new model at his hedge fund. Meanwhile, mainstream economists are still hard at work on their own theories, hoping to become the next Milton Friedman.

In Durham, North Carolina, I'm Janet Babin for Marketplace.

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