Rationality, fervor, clarity and a dose of snark

I can't pretend to be economically literate enough to judge how fair and accurate Justin Fox's The Myth of a Rational Market is. Subtitled "a history of risk, reward, and delusion on Wall Street," Fox has put the dominant theories of market behavior and the boom/bust cycle on a timeline. This works well for me; I always do better when I consider explanations of causation in historical context.

He describes his star character, the academic elaboration of market rationality, as

"an imposing of the mid[20th]century fervor for rational, mathematical, statistical decision making upon financial markets. ... But much was lost, most importantly the understanding -- common among successful investors but absent for several decades of finance scholarship -- that the market is a devilish thing. It is far too devilish to be captured by a single simple theory of behavior, and certainly not by a theory that allowed for nothing but calm rationality as far as the eye can see.

Resolutely apolitical and in this conventional, this history thus becomes a tale of the interesting, quirky, sometimes quarrelsome men who invented and reinvented academic finance.

The book is gossipy and predominantly good fun -- and for most the period, perhaps as late as the 1980s and 90s, its subject had little effect on the real economy in which most of us live and struggle to get along. The big casino was the playground of the rich, usually divorced from Main Street trends and troughs. (Yes, that includes the Great Depression which was not a follow-on from the 1929 stock market crash, but a much more general failure of dysfunctional interwar capitalism.)

The Reagan era substitution of 401k plans for defined pensions dragged far more of us into the financial arena -- and added distortions created by pension fund managers trying to navigate the market. At that point, the behavior of financial markets became clearly something far more people needed to concern themselves with -- and at that point the hegemony of rational market theory did work as a bulwark against society's democratic impulse to regulate an arena upon which the general welfare had come to depend.

Interestingly, in an aside to his story, Fox quotes the 18th century forefather of conventional economics saying something that many a contemporary victim of the recent financial follies would concur with:

In 1776, Adam Smith argued that the "joint stock company," as the corporation was then known, had proved an unmitigated disaster. "The directors of such companies, ... being the managers of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own," he wrote in the The Wealth of Nations. "Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company."

Yes, Smith would have understood about bankers and bonuses.

In a similar vein, Fox charts the evolution of an important recent theorist of rational financial markets, Michael Jenson. Jenson was a vigorous exponent of a certainty that markets worked out their own kinks and executives could manage well by simply working to increase short-term stock prices of their companies -- until intellectual honesty led him to conclude differently.

If market participants failed to follow a particular non-market-determined norm -- integrity -- markets wouldn't work. The market couldn't govern itself.

Fox's final chapter, "The anatomy of a financial crisis," includes as clear a short description of the operation of the house of cards that was the housing bubble, its associated flimsy mortgages that were securitized, and the incentives of drove even suspicious bankers to jump into trading what are now the scorned "toxic" fictional assets.

Fox makes this roller coaster ride of theory and practice pretty accessible -- and holds this reader's interest with frequent doses of pure snark.

His regular commentary on matters financial can also be found at at Time Online's blog The Curious Capitalist. Recommended.