Here’s Why Market Rationality is Elusive – with Justin Fox of Harvard Business Review

For the economist trying to understand the human condition in relation to markets, the question of what constitutes rational behavior is of central importance. Understanding what can make individuals “rational” in financial markets is what can help us explain the wild fluctuations in the prices and values of stocks and corporations over time. To further understand the types of behavior that underpin national markets, we sat down with Justin Fox of Harvard Business Review to ask a few questions. Justin is the author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion.

Wall St. Cheat Sheet: An important aspect of financial markets is the theory of the business cycle. Isn’t this something that investors can take advantage of and likewise reduce the inherent risks of a crash?

Irving Fisher, who I think of as the father of modern financial economics, talked about the “so-called business cycle.” He didn’t believe there was any inherent business cycle, just changes in the value of money (caused by central bank decisions or, before there were central banks, changes in the supply of gold and/or silver) that confused consumers and businesses and caused economic fluctuations. But Fisher seems to have been missing something. There are cyclical shifts in risk appetite, there’s Hyman Minsky’s progression from hedge finance to speculative finance to Ponzi finance, their is a tide in the affairs of men. It can be pretty hard to take advantage of the business cycle as an investor because the timing is always going to vary; it’s not a regular, predictable cycle. But sure, being aware that there are always going to be booms and busts is a first step toward protecting yourself.

Wall St. Cheat Sheet: What major variables lead to moments when the market is exceptionally rational?

Justin: Hmmm. Diverse groups are best at solving problems, so markets are probably most rational when opinions are most diverse. Some people are optimistic, some are pessimistic, there’s lots of debate and not so much herd behavior. This usually happens somewhere in the middle of the business cycle, I guess.

Wall St. Cheat Sheet: How have revolutions in technology played their part in making markets more or less stable?

Justin: Technological revolutions bring lots of opportunity and lots of uncertainty, which provides perfect conditions for the creation of a financial bubble. Such bubbles can also finance technological revolutions. The cause and effect isn’t always clear, but there does seem to be a link. This is apparently a big theme in the work of Carlota Perez, whose Technological Revolutions and Financial Capital is a book I’ve been meaning to read for a while.

There are also revolutions in financial technology (from the creation of the first publicly traded corporations in the 17th and 18th centuries to the derivatives explosion of the past few decades), and they tend to lead to trouble as well. Until a new financial product has been tested by a full business cycle, market participants have no evidence of the risks it might pose, so they underestimate those risks.

Wall St. Cheat Sheet: Can governments have a role in regulating market rationality?

Justin: Government regulators aren’t as a group obviously more rational than market participants–and aren’t subject to the same market discipline. So there are problems with regulating rationality. But the dynamics of bubbles and crashes are such that central banks do seem to be able to mitigate their worst effects. The problem is that, while the Federal Reserve always intervenes in the case of crashes, in recent decades it has been loath to do so in the case of bubbles. That kind of asymmetric approach obviously favors the bubble blowers, and probably results in more bubbles and crashes. (The book on this is George Cooper’s The Origin of Financial Crises.)

Don’t Miss: Justin Fox: We MUST Understand the Difference Between Longrun and Shortrun Economics.

Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.