killer buffalo

Why did the banker cross the road?  Because there was a $100 bill on the other side.  Why didn’t the economist?  Because he reasoned that if the $100 bill was real, someone would have already picked it up.

As it turns out, the bill was fresh from the Philadelphia headquarters of the United States Mint; what the economist thought was a piece of counterfeit currency was actually bailout money, planted on the other side of the asphalt for the banker who the federal government knew didn’t accept the idea of market efficiency.

President Obama and his administration predicted the banker would reason that if the efficient-market hypothesis (EMH)—the theory that the prices at which all financial assets are traded reflect all known information—held true, then commodity prices never would have spiked in the summer of 2008, real estate prices wouldn’t have increased by 50% from 2000-2007 and then since lost those gains, and the “dot-com bubble” wouldn’t be a case study on human psychology applied to economics.

Although many economic theorists still hold that investors are rational, and use the EMH as evidence that stock prices mirror real stock values and that outperforming the market is therefore impossible through any means other than luck, a growing number of financial economists are beginning to doubt the EMH.  Over the past fifteen years, free stock-trading websites have made available information that was previously difficult, if not impossible, to find.  And yet an increase in real-time financial information has correlated with an increase in bad investing—the dot-com bubble, the oil speculation bubble, and the American housing bubble have all come since then.

Because the price of a share of AOL in 1999, a barrel of oil last July, and a two-bedroom Albuquerque condominium in 2007 had little relation to their actual or potential value, something other than market efficiency must have been at work.

The EMH ignores the fact that humans aren’t good at calculating risk; it’s why we make bad bankers, and why we need to tame our actions by leaning on protocols like laws, etiquette, and ethics to govern our decisions.  But most importantly, it’s why we are subject to the herd mentality that creates the greater fool in the greater fool theory—the man who became a first-time homeowner three years ago or who bought copper last year because it’s month-to-month increases were seemingly guaranteed to continue.

Homo economicus—the “economic human” —doesn’t exist.

Herd mentality does, and it’s leading politicians to the wrong solutions at the wrong times.  Now, when every major investment bank has been closed, General Motors (GM) and Chrysler are nearing that fate, and most major Wall Street banks are in the red, Mr Obama has dismissed GM’s chief-executive, the 111th Congress has passed legislation regulating executive pay, and the president’s administration is working with Congress to force banks into freeing up the funding they received in the Troubled Asset Relief Program.

An investor doesn’t need advice after he’s lost all his money in a speculative bubble; he needed it when he was buying the “sure thing” peacock feathers stock.  Just so, business needs government regulation most during periods of economic growth and least during recession.  While the economy is expanding, lending practices can get sloppy, salaries can become bloated, and undue optimism can lead managers to taking on excessive risk.  Here, at the bottom of the business cycle, banks currently funded by the government are being run how they should have been years ago, lending cautiously and dismissing failing executives like the criminals they are— are now and always have been.

It may be difficult for Mr Obama and his Congress to understand that they aren’t needed during this time of crisis—or rather that their regulation isn’t.  It will surely be more difficult for them to explain that to outraged voters.  But look at the numbers—America’s personal savings rate, 4%, is higher than it has been in fifteen years and average CEO salaries are lower than they have been in nearly that long; the recession is making us all better calculators.

It will be several years into the future, in a world of rising stock prices, when one homo economicus will cry that an industry’s profits are unsustainable or its businesses overvalued.  Then Mr Obama will have a problem best fixed through government intervention.  May he fix it before the herd catches up with its own foolishness.

-David Lamb

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