Book discusses concept of rational market

The theory that financial markets always reflect the real value of the economy has been dominant since the 1950s. This theory has been used to justify the deregulation of the financial markets that some have identified as the cause of the last three recessions. In The Myth of the Rational Market, Justin Fox tells the story of this theory as it developed in economics and finance academia.

The title dramatically overstates both the argument and the conclusions of the book. Fox knows that to call the rational market mythical says little in the eyes of economists, since the rational market theory is merely a model—something that is not even meant to be true. Instead of exposing the model as a myth, the economists in Fox’s book demonstrate that the connection between the rational market theory and real financial markets is simply too tenuous for the theory to be useful by itself.

The Myth of the Rational Market is structured chronologically, beginning in the 19th century and running long enough to just touch on the most recent crisis. Fox explains the reasoning behind “rational markets” one professor at a time, profiling dozens of economists, mathematicians, and finance professors who helped to create and develop the theory.

The theory has its origins in the first half of the 20th century, but its rise to prominence began in the 1960s with the development of the so-called “efficient market hypothesis” by University of Chicago business professor Eugene Fama. The University of Chicago then became the epicenter of the further improvement of the theory, though professors at Stanford University and the University of Rochester also played major roles.

Even before the theory rose to prominence, criticisms were common. Economists and left-leaning politicians attacked the theory as a simplistic rationalization of the status quo. However, these concerns were defeated, dismissed, or ignored until the 1990s. By then, enough data had been collected that the efficient market hypothesis lost its empirical support, which came mostly from 1940s financial data. More behavioral approaches rose to partially replace the highly theoretical and mathematical methods that dominated academic finance and economics for decades; the rational market model lost its place in academia, though perhaps not as much as it should have.

Many professors still cling to the rational market hypothesis, because, in the words of Fama, the behaviorists have not provided any alternate “theoretical framework” that could replace the efficient market theory. The assumption at the heart of this criticism is that market behavior—financial or otherwise—is lawful in the same way that physics is lawful. The absurdity and arrogance of this assumption is part of the reason that economists and finance professors are notoriously bad at making long-term predictions.

That Fox did not expose or criticize this assumption despite having numerous professors use it is a testament to the ideological independence of his book. The Myth of the Rational Market is essentially a dispassionate history of an idea—all support for and criticism of the theory comes from actual experts. This is especially important in light of the fact that Fox is a mere journalist—equipped as a historian at best, not as an economist.

Fox’s devotion to reporting the history of the idea has also caused some problems. Foremost among them is that Fox barely even mentioned the rational market theory as popularized by Milton Friedman, Ayn Rand, and President Ronald Reagan. The purely financial version of the theory is certainly important; it seems to have played a major role in the last four financial crises and recessions. However, the economic version of the theory might be yet more important, since it is the logical backbone of modern American conservatism. Fox’s choice to ignore this permutation of the theory is regrettable, though it may have been a necessary result of his impartiality.

This should be thought of as a minor blemish on an interesting and valuable book. Though at times the epic of the theory can seem a bit slow and tiring, this history is also crucial to understanding the flaws and advantages of the theory as it currently exists. Though the academic support for the rational market hypothesis thinned, the theory is still a powerful element of the political ideology, and The Myth of The Rational Market may be the most fair and comprehensive of recent books seeking to free the hands of our government from that ideology.