A conversation with the business and economics columnist at Time Magazine.
Question: What is the appeal of the rational market theory?
Justin Fox: The basis of the theory is that Wall Street knows what it’s doing: that prices move on stock markets in particular, but financial markets in general, for a good reason—because all these investors and speculators are bringing all this information and opinion to bear, and are therefore delivering the best possible assessment of what a particular stock or bond or whatever else is worth. And part of the attraction of is, at some level, it is at least partly true. Stock markets are not completely driven by noise; they are not completely driven by irrationality. If they were, I think we would have decided to get rid of them at this point. Although, I guess a lot of people make money often so you never know. But, still, there’s some element of rationality and reflection of fundamentals going on in market behavior, so that’s one reason why it’s attractive.
The other reason why it’s attractive—especially the version of it that was born or reborn in 1960’s and really became incredibly influential in 70’s and 80’s and 90’s—it just makes life so much simpler. If you just simply go from the starting point that financial market prices are right, then you can do so many great things. You can calculate the cost of capital really easily if you’re a corporate decision maker trying to decide whether you want to do an investment or not. You can pick out an investment strategy that makes sense, that balances and risk and reward more appropriately, very easily. You can basically approach the market in this scientific fashion that can be taught to other people and handed down to other people. It isn’t all about gossip or people’s strange opinion. It’s the scientific straightforward guide to decision-making in and around the market.
Question: What alternatives to the rational market theory are being put forward?
Justin Fox: One of the fascinating things that’s going on right now is a bunch of economists, Paul Krugman and Brad DeLong among them, are trying to come up with pretty much rational explanation of bubbles: how bubbles work and what the interaction is between the leverage and bubbles, and what causes them. I’m fascinated by that. I don’t know if it will deliver any real answers, but it is an attempt to use the fact that—even [when] people who, in their individual position as a hedge fund manager or whatever, are behaving entirely rationally need to maximize their own well-being—it creates this system where markets go bonkers, and I think that the lessons that will probably come out of that is: leverage is dangerous. That’s really interesting to me.
Other areas that there are some people who would go head over heels for, and I’m interested in it and I talked about it at the end of the book, is this idea that maybe we can come up with different ways of modeling market behavior that sort of take the fact that investors are constantly learning, but at the same time that the markets that they are trying to understand are constantly changing—so it’s this constant process that [is] moving towards getting things right, but then markets continue moving away from that, so there is never any perfect moment. There is never equal equilibrium. And lots of people, some of them physicists, some of them economists, try to put together these various “adaptive markets” or, I mean, complexity is another term for part for this. It was very fashionable in early 90’s, everybody sort of forgot about it for a while, and now it’s back. I just don’t know where it leads. Nobody got any answers out of it yet as to how markets behave.
Question: What do you think of new investment models such as social lending?
Justin Fox: All these people want to come by and visit an economics columnist for Time, and I’ve been talking to a lot of these people. There is some potential for creating these, what basically amounts to securitized lending, but in a more transparent straightforward way. But I don’t know. At some level, I think we are still figuring out how a financial system actually works. We thought for a little while that all of this stuff has been solved by moving everything out of institutions like banks into markets. But it is just not that easy—debt markets turn out to be incredibly dependent on the rating agencies to tell investors what to buy or not, and they were worse than banks at determining what’s a good loan and what’s a bad loan. I just don’t know what kind of institutions are going to exist. It is very intoxicating to hear about a place like Kiva, which has all these people in the US making tiny loans to somebody starting a bakery in Peru. It’s all very cool, although Kiva has been so successful in part because there’s no attempt actually to make a profit off it. So maybe it’s not a business model, it’s just this new model for organizing charity.
Question: What motivated Robert Shiller’s unique economic views?
Justin Fox: Shiller, in a lot of ways, was a pretty conventional economist. He was trained at MIT in the late 60’s and early 70’s. His dissertation adviser was Franco Modigliani, who accidentally coauthored a couple of papers that led the way to the rise of rational market finance and economics. So it wasn’t like he was being educated by a bunch of hippies out in an Ashram or something. He was getting a very mathematical, conventional economic education. But at the same time, as told in the book, this idea rose simultaneously—and there was a lot of cross pollination at MIT in Chicago, but in MIT, there was always this sense of “Here is this great model for understanding how the market works, and we totally agree that the market is pretty hard to outsmart. We don’t know that it’s smart, but it is hard for other people to outsmart, but we we’re not sure that means that it is all working perfectly.” Whereas in Chicago, it became a project to show how great markets were and how much better they were than any government bureaucrat. So, all along, in MIT, from the beginning, it was this weird co-existence of this very rationalist theory of how the world worked coupled with this understanding, and a lot of classroom discussion about how the world didn’t work quite the way it was described in the mathematical models in the classroom.
So you see you [have] people coming out of MIT, and Shiller’s classmate, Robert Merton, a Nobel Prize winner—sort of a high priest for a while of this rationalist finance—was there at the same time, and came out with a very different world view. So Shiller came out with this conventional training, but he sensed that all these theories and models weren’t entirely right. He had a lot of computer skills and empirical skills and so he started during the 70’s to just try to test some of these theories about market behavior against the data, and initially he was looking at bond prices and didn’t come up with anything all that is explosive, but then starting [in] the late 70’s, he started looking at stock prices, and was trying to come up with measure [of] whether they reflected the fundamental value of the stocks themselves. He just compared stock prices to subsequent dividend payments, and found that the dividend payments were a lot less volatile than the stock price movement. And that [was] not proof of anything, a lot of people argued, all companies tried to keep their dividends [steady], therefore it shouldn’t mean that much. But other people did similar examinations of earnings, comparing [them] with stock prices, and basically the lesson was there [was] a lot of unexplained volatility in the stock market.
Later on, other people, including the pretty conventional finance scholars like Richard Roll of UCLA, basically confirmed Shiller’s observation, and so then Shiller actually went and paid attention to real estate for about ten years. But when he came back to paying attention to the stock market again in the middle-late 90’s, it was with this idea that [there was] this period when prices went off in directions that had less to do with anything going on with the fundamentals than [with] mood swings. That led him by the late 90’s to be this really prominent doubter about the bull market of those days. And then he came out with—he totally admits this was luck—the most spectacularly timed book of all time. In March 2000, he published Irrational Exuberance, and March 2001 is exactly when that exuberance started to tail off and end.
Question: What is Shiller’s take on the current crisis?
Justin Fox: So he wrote Irrational Exuberance in 2000, and then he went back to paying attention to real estate. And then wrote a new version of the ebook that came out in 2005, making the point that, “Wow! Real estate prices had gone really crazy by historical standards, and we can probably expect sometime in the next few years a collapse in real estate prices.” And so he is now even more of a guru than ever before, because he really did it at some level predict what happened. Not the details, not the timing, but he—at a time when conventional wisdom was that the real estate market was not a big danger—he was saying it [was] everyday.
What’s interesting about Shiller is his lesson that he takes from all this is not that we somehow need to shut down markets or regulate them vastly more. However, I think he will be in favor of some more regulation. But he seems to think that if we only had even more financial products, if we’re all buying and selling real estate derivatives betting that our house prices might fall, then we would have been better off. So it sort off comes back around to that MIT belief in markets and conventional economics in the end. And so he’s very often paired with Nasem Taleb, an options trader turned bomb-throwing market philosopher. And Shiller comes across as the conservative or the moderate in all these discussions now.
Question: Does the crisis disprove Shiller’s belief in the power of developed economies?
Justin Fox: His belief is continued growth of the financial system is a good thing: we just have these shakeouts where we figure out what doesn’t work. I guess my one caveat to that is, after he said that, I went back, and was trying to look at it—because finance people always bring this up—and there’s a lot of comparative global research showing that countries with better developed financials do better than those without them. But [that’s] mostly research about developing countries, and it sort of stands to reason that a country where nobody has a bank account is not going to progress as fast economically as one with their banks and loans available. But I think once you get to a well-developed economy with big financial system, I’m sure there’s some point of diminishing returns, and it’s pretty clear we reached that in the US over the past decade: where you get a financial system that sort of takes on a dynamic of its own and it is no longer serving the economy as a whole, but it’s just kind of turning towards it’s own path and sucking off lots of money from the system. I imagine we will start getting a lot of research now about whether there is any way to tell what’s that one point where financial system has gotten too big. And I don’t think Shiller would disagree [with] that. He just, in the end, still believes in finance and [that] it can do good things for the people.
Question: Are MBA programs responsible for the theories behind the crisis?
Justin Fox: I think [about this] a lot and the difficulty I always have is, I have this impression [that] you look at what is in the textbook of MBA finance courses that is being taught everywhere, and there’s an indoctrination going on, but when you start talking to MBA students—I have talked to several at Harvard who [said] “Yeah, we saw that in the class, but we never paid any attention to it.”
It is always hard to puzzle out the influence of the ideas that come out of universities on real life. The whole premise of the book [The Myth of the Rational Market] is that they do matter and they are important, but I’m a little hesitant to claim that that did everything. Definitely, something that came out of business world is the change that went on in business schools starting in the 50’s and the 60’s—this general idea that imparting lessons on how you are suppose to behave as an executive is not enough, you need this science that explains what is going on, and economics can offer a lot of things that look like science, especially lessons about how you incentivize people to behave in certain ways. That became really influential, and I don’t know how much every last MBA grad was inculcated with it, but it definitely spread out in the corporate world and in the 90’s I wrote about it.
And in some length in the book, this sense that “If only CEOs were paid in a way that incentivized them better to want to do right by shareholders, then this would be a better world.” And that turned out to, at some level, succeed in the early and mid 90’s, and [it] made corporate executives a lot more interested in shareholder value and maximizing stock price, but it also just reached the point of insanity by the late 90’s when this focus on stock price came to just [replace] things that actually create value for corporations over time.
Question: How should MBA programs change in light of the crisis?
Justin Fox: That’s the puzzle. One of the stories I tell right at the end of the book is: this young behavioral finance professor, very critical in his academic work of deficient market theory, [talks about] teaching MBA students at Harvard finance, and says that when it comes down to it, he’s still closer to believing that the market is efficient than they are, because there are all these genius MBA students at Harvard who think they are smarter than any market can be. So he ends up teaching pretty conventional efficient market stuff to the first-year students. He might then move on later to more complex things. And that is one of the fascinating things—there isn’t any sort of overarching replacement, and my sense is what should be taught is there isn’t any overarching model that explains everything about market. You should look at several different ones. I think that is always a difficult thing for people to swallow, when they had this very simple way of teaching how the world works. And suddenly you say, “Oh no, you know you have to use judgment in a lot of different ways.”
So my sense is that there is clearly a lot more interest among MBA students of other things besides incentivizing people with stock options and there’s [a] whole movement toward reciting oaths of honor when people graduate—they just suddenly took off this spring. So with the level of the students there is interest in other things, there is a sense among the faculty that maybe they got their focus wrong and their incentives wrong. But I don’t [know] and maybe I’m just not close enough on the ground to it. I don’t sense that there is wholesale replacement about to happen with some other way of teaching how markets work.
Question: Could a crash like this happen again?
Justin Fox: Financial markets get nutty. They have bubbles, they crash. That’s part of capitalism. It’s been there from the very beginnings: since financial capitalism started. And sometimes bubbles and crashes are big economic disasters. Sometimes they’re not, and we look back at them somewhat fondly—like the dotcom bubble. It left some in infrastructure in place. It left a lot of people with skills, and startup companies in place. Definitely, there was a hangover, but it wasn’t an economic disaster. When you think about it, the real reason why is because that was not a bubble built on debt—it was a bubble built on people’s expectation and fantasies, or what this companies would be worth—but they were putting equity into it, putting cash into it [when] there was no promise that they’d get it back. And so when they didn’t get it back, they didn’t get it back.
When you build a bubble upon debt, like we did in housing, it leads to this much more difficult situation, where suddenly all these people thought they’d given money to somebody who is promising to pay them back. And suddenly, a huge percentage of those people can’t pay back because their assets weren’t worth what they paid—anywhere near what they paid—anymore and the economy is struggling. So it’s some link between debt and markets, that’s the problem. So it seems like the most important thing is going for some sort of structure that reduces leverage, especially in boom times.
Question: What foreign countries have better economic regulation than the U.S.?
Justin Fox: Well, it’s been interesting in this crisis. A lot of people have looked at both Canada and, to a large extent, India, and to a lesser extent at countries that just kept their banks from getting in too deep. It’s hard to identify whether there are some structures that made that happen, or if there just happened to be the right regulators in place at the right time. Because one of the things that’s interesting—in the US there’s a lot of talk now like, “We need to break down financial institutions, make them smaller. So it’s okay if they fail.” But you look at Canada, which has been very successful at navigating this financial crisis, there they’ve got basically four or five banks that matter. They’re all too big to fail from a Canadian perspective. And yet things worked fine.
Economically speaking, I would say the Scandinavian countries have this wonderful balance of providing a safety net, but at the same time understanding that they are competing in the global economy: you need to have a tax system and other things that are competitive. So at that level, I’d say those are great examples. In terms of financial regulation, I just don’t know. I mean, one of the things all of us funded to the US complain about is how we got a zillion different banking regulatory agencies and they are all sometimes cross-purposed and things fall between the cracks. But then, the UK has a universal regulator that is in charge of every financial system. And they’re the other country that did the worst in this crisis along with us. So I don’t see any obvious model other than people doing their job better, as they did in the few countries like Canada and India.
Question: How will banking in the U.S. change as a result of the crisis?
Justin Fox: A lot of people say that we seem to be moving in the direction of having a smaller group of even bigger banks dominating our financial system. And maybe a couple of years down the road, that will start to change, and [we’ll] decide that it’s too unwieldy to have Bank of America and Merrill Lynch, and start breaking [them] up, and that would partly solve the problem.
I think part of it has been remembering a lesson that was learned in the 30’s and since have been forgotten, which is that if you want to have a banking system that doesn’t collapse every few years, you need to have a government role in it. People have looked nostalgically back to the 19th century where there were rashes of bank failures all the time. On the flip side of that, you [had] far less finance and a much less developed financial system, and [it was] much harder to get financing to start companies to buy houses, to do whatever else. So you could have that kind of system where everybody is just used to failure every few years, but then you probably have a smaller economy [with] much less lending over all.
So I think there has been this understanding by a lot of interesting people on the conservative side. Richard Posner, the federal judge in Chicago and law professor, is the most obvious example. We realize that there’s a reason for bank regulation. There’s a reason why we have it. There’s a reason why we keep banks from taking certain risks. So I think that’s back, and people understands that’s what we’ve got to see looking forward, because what happened over the past 20 years is that banks per se were still restricted from taking risk.
Then, even before Glass Stengal was repealed in 1999, subsidiaries of bank holding companies were allowed to engage in all these really risky behaviors. And I think now there’s this understanding that, “Okay, [what] all these other people were doing is—if it involves lending, it’s basically banking, and it should probably subject to the same set of rules that we had before.” So I guess the big difference is there’s been a reaffirmation that there is a reason for banking regulation, and there has been this realization that all these things that didn’t call themselves banks actually were banks and are subject to the same risks and runs that banks were and therefore we need to think differently how to regulate them.
Recorded on: June 30, 2009