Why Do "Efficient Markets" Economists Think a Speech by George W. Bush Caused the 2008 Financial Meltdown?
Justin Fox on journalistic paywalls and the Chicago School:
John Cassidy's illuminating visit to the Chicago School: I did briefly consider saying something about John Cassidy's edifying and entertaining New Yorker piece on Chicago School economics, which I read while eating breakfast and making Curious Capitalist Jr.'s lunch this morning. But when I looked it up online, I discovered it's not online. Well, not unless I could type in my subscriber number. And guess what? I have failed to memorize my New Yorker subscriber number! There is an audio interview with Cassidy available to all. And as I'm about to go work at a place that puts lots and lots of stuff behind a paywall, I really better not complain too much. But still: Frustrating!
Now I'm back home with a paper copy of the New Yorker in front of me. And the article's still good. Cassidy talks to three sorts of Chicago scholars. There's my buddy Gene Fama and his son-in-law John Cochrane, who by defining all the accomplishments of post-World War II financial theory down to the commonplace observation that it's hard to outguess the market are able to argue that there's nothing wrong with this theory. They may be right, but they also don't have much of anything interesting or useful to say about the events of the past couple of years. They have defined themselves out of the discussion...
Actually, I think Justin is wrong. It's much more than defining themselves out of the discussion.
Cochrane says more than that it's not possible to outguess the market. On the one hand he wants to say that there is no evidence that financial markets are not "efficient." On the other hand he wants to say that President Bush by giving a speech caused the stock market to crash--push it down in value by one-third--and caused the bond market to freeze up:
[T]he President gets on the television and says the financial markets are near collapse. On what planet do markets not crash after that?
Now when the stock market's dividend yield is 3%, fully 75% of the present value of stocks comes from dividends that are to be paid more than a decade hence.
Unless you think that one speech by President Bush had a profound effect on dividend levels and discount factors in 2019 and beyond, you simply cannot (a) know enough about the dividend-discount model to remember that at a dividend yield of 3% three-quarters of the present value comes a decade and more hence, (b) claim that the market is "efficient," and also (c) claim that a speech by George W. Bush caused the meltdown.
Chicago School of Economics Circles the Theoretical Drain: [A]n alternatively depressing and fascinating piece by John Cassidy about how the Chicago School of economics – monetarism, rational expectations, efficient market theory, etc. – is circling the theoretical drain. While some economists are abandoning the faith, many are not, and the result is, as Cassidy says, much like what happened in cosmology with Edwin Hubble discovered the expanding universe: Economists have lost their footing and are engaged in everything from rear-guard actions to active peer denunciations, and pretty much everything in between.
The following quote from Chicago economist John Cochrane jumped out at me, however, in its mealy-mouthed implicit apologia for the theoretical status quo:
What is there about recent events that would lead you to say markets are inefficient?” he said to me. “The market crashed. To which I would say, We had the events last September in which the President gets on television and says the financial markets are near collapse. On what planet do markets not crash after that?
The only reason the markets crashed in 2008 was because the U.S. President got on TV and said they might? Leaving aside that heads of state say stupid things about markets, both in the U.S. and elsewhere, all the time and nothing happens, that is just dumb. By that point we had had an unprecedented run on the shadow-banking system, assets for many banks looking like zero, Fannie/Freddie as state wards, banks up to Goldman and Merrill wobbling, and it was the President that made a crash happen? Simply staggering – and, in its fact-free and inflexible defense of a particular economic ideology, a crushing indictment.
But, as I said above, it is not a defense of the efficient-markets ideology. 75% of the present value of the market depends on dividends and discount factors more than a decade in the future--dividends and discount factors that can in no conceivable way be affected by George W. Bush's speech.