Irrational Expectations
<p>The reactions to my posting on the economic case against the GPL reminded me yet again why failure to understand basic economics often becomes more toxic in people who think they understand a bit about the subject. In this mini-essay, I&#8217;ll take a look at the most important (and misleading) of the superficially clever arguments I saw in responses.</p>
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<p>Here it is: <b>Markets don&#8217;t seek efficiency because investors aren&#8217;t rational.</b> Yeah, well, gas molecules aren&#8217;t rational either, but they obey very simple regularities in large numbers. Rational-expectations theory doesn&#8217;t actually require individual investors to be rational, it merely predicts that en masse they will behave <em>as if</em> they are rational.  </p>
<p>Reality backs this up; if investors weren&#8217;t good at rapidly folding information into prices, it would be possible for humans to beat the stock market by applying an algorithm &#8211; but, in fact, even the savviest professional money managers notoriously do no better than chance over long periods.</p>
<p>&#8220;Over long periods&#8221; &#8211; timescale is important.  Computerized trading can, in some specialized ways, beat the stock market, but only because it can react faster than a market mostly composed of humans can equilibrate.  Speculative bubbles affecting the entire market are  random excursions obeying a sort of power law &#8211; the more irrational they are, the more quickly they pop.</p>
<p>Unless, that is, the bubble is being continuously pumped by a political failure.  The debt crisis that has spun the U.S. into recession is often portrayed as a sort of inevitable comeuppance of free-market capitalism and speculative greed, but it doesn&#8217;t take a lot of digging to discover that massive policy errors underlie it. Many of these are mistakes that neoclassical and Austrian economists have been sounding warnings about for decades to no avail.</p>
<p>Here&#8217;s one: the Fed held real interest rates artificially low for decades before the CDO collapse, pumping the speculative bubble in real estate.  Here&#8217;s another: an unknown but probably large percentage of those non-performing mortgages were issued by banks under political pressure to make enough loans to poor people (especially poor people who weren&#8217;t white) through regulations like the Community Reinvestment Act. Here&#8217;s third: Fanny Mae and Freddie Mac were operated as a campaign-cash cow and fountain of patronage jobs by a coterie of powerful politicians. Mainly, though not exclusively, Democratic politicians, which is why the Obama administration has no interest in investigating the corruption and self-dealing that went on there.</p>
<p>Here&#8217;s a safe rule: whenever you hear a politician huffing and puffing about market failure, make the largest bet you can that he is covering for a regulatory or political intervention that actually created the problem, usually one he was personally involved in perpetrating. You are extremely unlikely to lose.</p>
