English major and Marxist social critic Rob Horning reviews The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street by TIME magazine’s Justin Fox:
Fox’s account of the rational market revolves around the long-held dream of discovering a method to pin down the intrinsic value of an asset—what it should trade for, so that mispricings could be systematically exploited by investors and the potential for bubbles negated. Unlike Marx, who, drawing on Ricardo, tried to trace value back to the notion of socially necessary labor, 20th century economists start from the premise that markets alone reveal the “true” value of assets by aggregating all the information gathered by all the various parties participating in exchanges and transmuting all that data into a simple, immediately comprehensible metric: price.
Austrian economist Friedrich Hayek wrote the classic exposition of the idea in The Use of Knowledge in Society. Hayek noted that “the ‘data’ from which the economic calculus starts are never for the whole society ‘given’ to a single mind which could work out the implications and can never be so given.” And economic conditions are changing by the moment, requiring different responses and different calibrations of potential future returns. Therefore, no group of bureaucrats can ever be in a position to plan economic development, à la a Soviet Five-Year Plan. Instead, a “rational economic order” requires markets, which serve as mediums of information exchange as well as the exchange of goods.
It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
Moreover, the market allows participants to make economically sound decisions without particularly knowing why. “The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.”
But this seems to present a conundrum. Market participants are expected to use their unique and specific knowledge to take advantage of errant prices and thereby correct them. In financial lingo, this is known as arbitrage. But at the same time, they must accept the information that a price is an accurate reflection of conditions they can’t be aware of and aren’t qualified to second guess. So they are in the position of having to trust the market’s wisdom while simultaneously correcting it. They have to understand their own limits and constantly exercise subjective, contingent judgment.
To his credit, Hayek recognized this: “Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people’s knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain.” In other words, economists must be careful not to assume away the gap between the isolated, subjective views on the economy and the unknowable totality of objective reality, or to ignore the perpetual need for individual judgment.
But as Fox’s account so punctiliously reveals, influential economists and finance scholars would repeatedly ignore Hayek’s warning in favor of pursuing financial “innovation” that has since been proven specious at best. They chose to overlook the psychological vagaries involved with market behavior—the Keynesian concern with investor confidence and “animal spirits” as well as the decision-making anomalies later taken up by the behavioral economics movement, which Fox covers at the end of his book—in favor of formulas built on the presumption that investors always acted with predictable rapacity and efficiency. Perfect judgment was conveniently regarded as automatic.