Exploring the rational market theory

Harvard Business Review Editorial Director Justin Fox.

TEXT OF INTERVIEW

Kai Ryssdal: It may not be what you want to hear in the middle of the worst recession in 75 years, but the market? It has no idea what it's doing. Believe it or not that's a fairly recent discovery. There was a model that dominated economics for almost 40 years. It's called the rational market theory. And what it said, in a very brief nutshell, is that the market is always right. That if the Dow closes at 8500 on a Friday and falls 300 points the following Monday, that's what's supposed to happen because the market is rational. It sounds crazy, I know, but it is a really important concept. And to explain why we've called Time Magazine columnist Justin Fox. His new book is called "The Myth of the Rational Market."

JUSTIN FOX: I think what started this whole way of thinking was a lot of research done in the late 50s and early 60s sort of revealing that mutual funds in general didn't beat the market. That any sort of new news about a company was reflected almost immediately in its stock price. So I think a lot of people saw that research and put it all together and thought, OK this means the market, you can't outsmart it. And if the market can't be outsmarted that must mean it's really smart and that the prices on the market are right.

Ryssdal: Well, then, how do we explain something as completely non-rational as the dot-com bubble and the housing bubble. I mean those kinds of things sorta of seem irrational on their faces.

FOX: Well, and they've basically caused almost everyone in academic, finance, and economics to retreat from this idea that the market is rational. But I still feel like, especially in the 90s, and to a certain extent in the last few years, this belief that the market knows best even when it was somewhat discredited still had this great power in society among financial regulators, definitely at the Federal Reserve. And sorta steered our actions during the housing bubble and the dot-com bubble.

Ryssdal: Explore that a little bit farther. By steering do you mean that belief in this theory of the rational market, did that cause regulators to back off a little bit, and say, you know what, the market is going to figure this out. It's going to take care of it.

FOX: Yeah, I mean with the housing bubble that's very clear to see because Bob Shiller, who's sort of one of the great rebels in my book, the Yale economist who has been kinda arguing against the rational market idea since the late 70s. He'd been saying for the past seven or eight years, gee, look real-estate prices have gone up faster over the past few years than at any time in recorded history that probably means they'll eventually fall. And all these economists at the Fed and elsewhere would write papers basically starting from the point, well, they probably rose for a reason. Let's write a paper discussing all the reasons why they've risen so much. And I think that ended up being this excuse for inaction on the regulatory front.

Ryssdal: Why do you suppose it is that for so long and in the face of contradictory evidence, so many smart people hung on to this idea? I mean, it took Alan Greenspan like 45 years to finally come around and say, you know what, this market makes no sense.

FOX: I think with Greenspan it was partly personal experience in the late 90s where he was dubious of the rise in stock prices, and he got up and made a speech about irrational exuberance. And the market made him look stupid. And he writes in his memoirs that basically he decided then that was my last attempt at trying to argue the market down. And so I think part of this is just this natural consequence of a rising market.

Ryssdal: So we were all suckers, right?

FOX: Yeah.

Ryssdal: As we bounce along the muddy bottom here of this recession and hopefully find some turn on the upside in the not-too-distant future, what's the model of the market going to be?

FOX: To me the point is not finding the perfect model of the market. It's sort of realizing that the market is a great thing. But I do think over the past 15, 20, 25 years that we've moved more and more towards sort of just deferring to the market. And I think it's healthy to have periods when we don't do that. When we still have the markets, and we still rely on them to do things, but we're constantly challenging the outcomes that they deliver.

Ryssdal: So if 15, 20 years of rational market belief led regulators to pull back, can we now assume, knowing that the market is not really rational, regulators are going to step in again?

FOX: Obviously one of the problems is regulators are probably irrational too. I know I'm irrational. And so there's not any perfect solution here. We're going to have market bubbles and busts. That's just going to happen, and I don't think we should try to stop it. What's really dangerous is lending money based on asset values during a bubble like that. So I do think one of the things we're going to get out of regulation is restrictions on leverage, on borrowing, and that makes a certain amount of sense given the story I tell in my book.

Ryssdal: Justin Fox is a business and economist correspondent for Time Magazine. His book is called "They Myth of the Rational Market." Justin, thanks a lot.

FOX: Thanks for having me, Kai.

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