Two opposing economic theories have driven investment strategy and economic regulation over the past century. Recently a third theory, largely ignored since the Great Depression, has entered the fray. That theory may hold the answer to when our current financial crisis will end or, at least, how we can avoid the next financial catastrophe.
When I was studying for my MBA a few years ago, the debate in every Finance case boiled down to two theories:
- The market is efficient, that is, value and price are essentially the same thing and day-to-day fluctuations in value can be explained by the constant flow of new information into the market. Giant changes in the value of a stock correspond to ‘shocks’ to the company or to the economy in general. These shocks are random, and the best way to model future shocks is to flip a coin.
- The market tends towards efficiency, but in the short-term it is driven by mass-psychology, and changes in stock price can be explained by the extent to which investors are distracted by, and over-react to, new information. While the price of a stock may eventually reflect the inherent value of the underlying security, discrepancies between price and value are irrational, and the best way to model these future shocks is to ignore them.
Investors who subscribe to the efficient market theory attempt to explain the apparent randomness of the market by using the mathematics developed by Albert Einstein to explain the Brownian (or random) motion of particles. In an interesting footnote to the history of economics, this work comprised Einstein’s doctoral dissertation. Taken to its extreme, the efficient market hypothesis seems to argue that gambling and investing are indistinguishable.
Investors who subscribe to the second view follow the fundamentals analysis framework proposed by Benjamin Graham and perfected by Warren Buffett.
Both philosophies, like the wonderful one hoss shay, coexisted peacefully for one hundred years to a day. At times, exceptions to either theory would provide fodder for proponents of the other school. Benjamin Graham went broke during the Depression waiting for the market to recognize the underlying value of his various investments, and Merton and Scholes, the Nobel laureate efficient market theorists at the helm of Long Term Capital Management nearly brought the world economy to its knees in 1997.
With the current economic crisis, both philosophies seem to be falling apart at the same time. Buffett has insisted that ‘now is the time to buy’ since the end of last year, even as the market continues to experience sharp declines. Buffett’s philosophy is to search for the unsinkable ships of industry, and to largely ignore the icebergs floating around in the next economic cycle.
Meanwhile, the efficient market theorists keep insisting that the laws of supply and demand will eventually restore the economy to a steady state…and they largely ignore the problem of irrational exhuberence and irrational pessimism. As the market falls, the efficient market theorists proclaim, stocks should become ever more desirable to investors. The problem, of course, is that stocks actually become less desirable to investors as they fall, because each dip in the market is another piece of evidence against looking to equities as a viable investment for the future.
Enter a third economic theory, known as the Financial Instability Hypothesis. Like Buffett and Graham, proponents of the Financial Instability Hypothesis reject the idea that the market is always stable. But unlike Buffett and Graham, they recognize that the markets may never be stable (and, hence, an apocalypse is within the realm of possibility). Hyman Minsky, the father of the theory, is also the namesake of the so-called Minsky Moment, that point of inflection when the credit markets begin to dry up. While Minsky is getting all the credit for this forgotten theory, George Cooper, author of The Origin of Financial Crises, writes that “many of the essentials of Minsky’s theory had already been presented by Irving Fisher in 1933 and…by Keynes in 1936.”
So here we have a theory that was conceived in the Great Depression, and now that we’re in the midst of another economic meltdown, it’s suddenly in vogue again. Just as the last veterans of the Depression retired from industry, just as we packed our elders off to the nursing home and dismissed their explanation of the Minsky Moment as, really, a Senior Moment, we find ourselves in another Depression, and one that threatens to be even worse than the first.
Cooper writes in the preface to his book, “history suggests that regulation designed for the last crisis does not prevent the next.” And, indeed, we’re finding that the legislation that pulled our country out of the Great Depression is proving inadequate for the challenges of our current crisis. So what is the answer…how do we keep this from happening again?
Cooper argues that you can’t have a functioning economy without a little instability. The problem with the central banks is that they don’t act as myopic governors but, rather, cater to the political whims of their home country. The US Federal Reserve jumps in whenever things look bad, but they don’t do much to combat irrational exhuberance. In Europe, the opposite seems to be true: there, they dutifully take away the punchbowl just as the party is getting started, but they’re slow to react to downturns (case in point: the Fed lowered interest rates last year several weeks ahead of the EU, causing a momentary devaluation of the dollar).
The economy is inherently inefficient and unstable. It may even spiral into chaos without constant attention by the central banks. But central banks should not care whether the economy is growing or contracting. Instead, they should only care about whether the economy is advancing to one extreme or another.