Satyajit Das: “EMH Funeral Oration”

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

John Cassidy (2009) How Markets Fail: The Logic of Economic Calamities

Like Mark Anthony with Julius Caesar, many have now come to bury the Efficient Market Hypothesis (“EMH”) rather than praise it. Amusingly, some of the critics who have recently found their voice are those who for years made their living from financial markets that were predicated in no small measure from the intellectual dogmas that EMH was central to.

In his previous book Dot.Con, John Cassidy, a writer for the New Yorker, provided a penetrating history of the Internet bubble and its bust. In How Markets Fail, Mr. Cassidy attempts a critique of modern economics. In this regard, he covers similar ground to Justin Fox’s The Myth of the Rational Market and Pablo Triana’s Lecturing Birds on Flying.

At its best, How Markets Fail provides a vivid history of recent economic thought and its influence on events that laid the foundations of the global financial crisis. Drawing on anecdotes and interviews, Mr. Cassidy provides an accurate outline of the developmental trajectory of modern economies.

His description of a noted confrontation between Raghuram G. Rajan and orthodox economists led by Larry Summers and members of the Fed, at a Jackson Hole meeting is revealing. Rajan, then the chief economist of the International Monetary Fund, warned about the risks embedded in the financial system. His detractors blithely denigrated the concerns on ideological grounds.

Mr.Cassidy also attempts to extend the text to encompass a critical review of what he calls “Utopian Economics”. The central focus of the criticism is that society is best served by individual self-interest and free markets. Mr. Cassidy’s argument is that individual self interest does not work, markets frequently fail, price mechanisms are flawed and markets are plagued by problems of information asymmetry – different levels of knowledge between participants.

In his criticisms, How Markets Fail is perhaps a little too eager to embrace behavioural economics and the work of Hyman Minsky. Useful as both alternatives are, they are also incomplete explanations of the complex economic and financial relationships.

In the final section of the book argues that it was these failures that led to the disastrous sequence of events that caused the global financial crisis.

Well written and researched, How Markets Fail is superior to the growing list of titles that cover similar ground. Mr. Cassidy largely succeeds in his objectives although the book does not extend the debate. The book undoubtedly will introduce a new generation of readers to the debate and encourage further debate.

There are some contentious and erroneous pieces of analysis of individual technical elements of the theory. In this regard, Donald Mackenzie’s brilliant An Engine Not A Camera provides a more technical and deeper analysis of aspects of the theory.

Recent criticism of the EMH, Chicago economics and “free market idolatry” tends to gloss over some interesting anomalies. Markets are rarely entirely free and regulatory failures were a contributing factor to many of the problems that have emerged. That is not to make the case for unfettered ‘red tooth and claw’ capitalism but to point out that many proposed regulatory interventions will not necessarily have the intended effects.

All economics is deeply embedded in a political, cultural and sociological framework. In many ways, it is symptomatic of these underlying issues.

For example, the analysis of sub-prime mortgages misses several factors. Firstly, a lack of growth in real income, especially for middle and lower paid employees, made it difficult for them to achieve the material success that was daily sold to them by the media and advertising. Secondly, the rise of stated income and low or no documentation mortgage reflected the change in work practice where large parts of the work force were no longer employed full-time. Casual or part-time employment and contracting arrangements made the required proof of income difficult.

Interestingly, many problems arise from the lack of humility about the theories. They are, at best, incomplete and highly conditional models that compare unfavourably to middle-age medical and religious superstitions.

Robert Merton articulated this concept precisely. “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.” Ironically, the speech was less than a year before the collapse of LTCM. Writing in 1995, Merton foreshadowed the events that were to unfold 3 years later at LTCM: “any virtue can become a vice if taken to extreme”.

As recent events in Copenhagen suggest, the only thing that history tells us is that mankind generally are poor learners. Mr. Cassidy quotes a recent column by Harvard’s Greg Mankiw: “despite the enormity of recent events, the principles of economics are largely unchanged.” Professor Mankiw suggested that student still needed to learn about “the efficiency properties of market outcomes.”

How Markets Fail is perhaps merely a sub-set of a wider phenomenon – How Mankind Fails.

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  1. vlade

    Thanks for the review, and the thoughtful addition –
    tt is rare today to see balanced view. It’s fashionable to cry “free markets failed”, even though the markets were anything but free. It’s less fashionable to build the discussion on which – if any – markets could at least approximate the “free” markets, and what to do when we have natural markets that will (from their nature) be never “free”. The famous shades of gray. But that doesn’t make for nice fight.

    Re the models, I used to say models give highly precise but even more highly inaccurate answers. Unfortunately, the precisions tends to impress, and inaccuracy is easily glossed over.

  2. DownSouth

    Nice review. It sounds like a book well worth the read.

    In the Age of Reason, orthodox economists fulfill the same role for the industrial and financial classes as Christian priests did for the aristocracy during the Middle Ages. They give moral and intellectual legitimacy to the ruling class.

    If this is indeed the death knell for orthodox economics, it is a watershed event that compares in importance to the demise of geocentricism.

    But one shouldn’t expect the industrialists and financiers to just give up the battle. As Reinhold Niebuhr wrote in Moral Man & Immoral Society, “When power is robbed of the shining armor of political, moral and philosophical theories, by which it defends itself, it will fight on without armor; but it will be more vulnerable, and the strength of its enemies is increased.”

  3. steelhead

    Wow Deep, I was going to make a lament that so few NCers bothered to respond to such an interesting review until I read yours. I wonder how many out there have read Niebuhr. Allow me to add to the Niebur’s concern. It isn’t just political, moral and philosophical theories that support power – sophistry and opinion-shaping play huge roles. Sophistry, combines with information asymmetry to make casual investors dupes to be fleeced in inverse proportion to regulatory control, and the equating of free markets with individual freedom makes the American public, wildly protective of individual freedom (Note: of late, security has displaced individual freedom), even less likely to press for aggressive regulation. Das does a good job of pointing this out – to anyone who might actually notice.

  4. Anonymous Jones

    It really is a sad commentary on humanity that we are still engaged in a debate about whether markets fail. Obviously, there are externalities and information asymmetries in all but the most commodified markets. I try to always think critically about what I *don’t* know, but this is just absurd; it’s like engaging in a debate about what two plus two equals. I don’t care how many fellow members of my species are duped in this matter; I can no longer countenance even treating these arguments as reasonable.

    This is certainly a nice review, and I thank Das for his thoughts (and Cassidy for continuing the fight against the sophistry, self-delusion and ignorance that come from both the leaders and the followers of this fantasy cult), but I can’t see myself wasting time on a book that’s taking apart a principle like EMH that is so preposterous and so easily refuted by everyday experience.

  5. Michael Fiorillo

    It’s nice to see wage stagnation (shrinkage, really), the rise of part-time employment and contracting-out receive their due as root causes of the crisis.

    Can we now add the multi-decade assault on unions as part of that?

  6. Jim in SC

    I just finished one of the other books mentioned, The Myth of Rational Markets by Justin Fox. Notwithstanding the title, Mr. Fox concludes that, while the EMH has flaws, it is not ready to be replaced by behavioral economics or any alternative theory. Like Newtonian physics, it works most of the time. I look forward to reading the Cassidy book, as I loved DOT.CON

  7. steve from virginia

    Just another bit of economic blather by a commentator who does not mention energy.

    Our slow- motion train wreck of global – and national – economies is an outcome of decreasing availability of crude oil relative to demand. The cheap oil is gone/wasted, what remains is too expensive to support commerce at a rate that provides adequate wages … or business profits, for that matter.

    It is an easy test to apply: as time passes, the Potemkin ‘recovery’ will prove ephemeral as there is nothing to produce except speculations and sovereign borrowings. When these fail there will be naught. Claims will prove uncollectable. It’s not hard to see how that ends up.

    Naught. Naught. Naught.

  8. Seal

    a few quotes from Benoit Mandelbrot

    “Continuity is a fundamental assumption of conventional finance.”

    “Human Nature yearns to see order and hierarchy in the world. It will invent it if it cannot find it.”

  9. Rishi

    Markets work when there are too many independent brains making decisions and they have more or less similar money power. However when there is oligopoly of few large players then it can break down because few decision makers can always get irrational risking money of big numbers of people. Create perfect competition and prevent consolidation from creating oligopolies

    1. aet

      Yes! That’s the answer!
      I’ll make the changes to the settings on my magic wand right away to “create perfect competition”.

  10. Siggy

    Never bot the EMH, wonder why so many have. This review is more vauable than the book because it tells me that I need not bother with the book. But then, has Das really given us a fair representation of the book?

    So much of the current financial distress is rooted in fraud that I can see that there will be a viewpoint that holds that the theories and hypotheses are still valid because events have been caused by externalities.

    Interesting folly that point of view; or, black swans are prevalent than anyone knew. Is there a model for the probability of there being the occurance of an externality?

  11. DellaTerious

    When the largest advocate of EMH, the Fed, insists via the Fed’s article “In Defense Of Secrecy”; that transparency is something capitalism can’t endure, then EMH is DOA.

  12. Lord

    The flaw of efficient markets is to equate price to value, making price the fundamental value, forestalling the real search for value, and defining markets as efficient rather than ask the tough questions of how efficient it is and whether that efficiency is increasing or decreasing. Until we go beyond it, we will get nowhere.

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