Semi-Appreciation: The Myth of the Rational Market

Justin Fox says his new book, "The Myth of the Rational Market" "is a work of journalism." He's right on that, and in this case, it is nothing to brag about. He's put together a highly entertaining collage of anecdote and apt quotation (there, thought ought to make a nice jacket blurb). But if you are looking to get your hands on the history of modern finance, you're going to look someplace else. He may offer the illusion that he is conveying knowledge but there is really no place in this porridge where he offers anything into which you can sink your teeth.

Start with the title: "The Myth of the Rational Market." Nowhere does he specify what he means by "rational" or "market" or "rational market" (nor, for that matter, "myth"--a word he quits using after the first chapter). At times he seems to be trying to build his story around the "Efficient Capital Market Hypothesis"--, ECMH, Eugene Fama's proposal (since rejected by Fama) that securities prices impound information that might affect securities prices. But from the get-go Fox seems to be treating "efficient" as synonymous with "rational." It isn't clear whether he sees no distinction, or figures that the reader will not see a distinction and so it's not worth sweating.

Either way, it is pretty clear that he wants to extend the definition far beyond the realm of securities prices; he seems to extend it at times to the behavior of all markets; to the principles of social organization in general; to the motivational scheme of politicians; to classic economic modelling; to modern macro theory, and perhaps to other realms that I haven't kept track of.

All these cannot possibly belong in the same bin. As an example, he seems to associate ECMH with the anti-state pro-market bias we associate with "Chicago School" economics. As an empirical matter, his own evidence defeats him. He points out that Fama himself is almost perversely apolitical and that other major players (e.g., Franco Modigliani) were avowedly leftish. Beyond that, the association seems untenable on its own terms: there is absolutely nothing about ECMH that requires or presupposes any particular form of state-market relationship (unless the mere existence of a market is thought somehow to be a political choice).

Beyond: the arguments in favor of the superiority of the marketplace over the state--some of those arguments are empirical ("markets work better"); and some are unreservedly moral ("markets are right"). But ECMH offers no parallel. Except insofar as it may seem to privilege the exercise of individual critical judgment, I should say that ECMH has absolutely no moral content whatever. It's just an observation, true or not true as the facts me dictate.

Beyond ECMH per se, Fox does canvass a broad range of material from critics or challengers of ECMH, although his presentation is not well organized. He needs to sort out, for example (a) structural distortions, like agent misbehavior, that serve the agent while disserving efficiency; from (b) "human limitations" as we see in Tversky and Thaler; and from (c) the analysis of bubbles, as in the work of Shiller or Minsky (indeed, Minsky seems to have been slapped on as an afterthought--perhaps Fox, like so many finance academics, had not really noticed him until the current uproar began).

But then for some reason he feels he has to go on and try to tackle virtually every other topic in modern finance theory (diversification pricing, beta; also rational expectations, public choice, valuation theory and a whole lot more). And not just to tackle them; to maintain the pretense that they all assimilate to a single intelligible theme. No, actually it may be they all assimilate to a single theme, but Fox has not shown that he has found it. And there is an ironic side-problem: by trying to attend to so many issues, he ends up giving short shrift to the one issue--option pricing theory--that may be more important than all others, including ECMH itself.

The result, then, reads like a career's worth of reporting notes, readable in themselves but far too diverse and scattered to offer much real insight. Fox said that it's journalism and I said it shows. But that is uncharitable. A lot of really helpful and instructive analysis begins as journalism. This book begins as journalism and pretty much stays where it is.