In a new column in the Financial Times, Richard Thaler expands on some earlier thoughts about the efficient market hypothesis by way of a review of Justin Fox’s new book, The Myth of the Rational Market.
What lessons should we draw from (the last two years)? On the free lunch component there are two. The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist. On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?
Read the full piece here.
Nudge blog 
September 1, 2009 at 7:47 pm |
The “bubble” in Japanese land values (Tokyo was worth more than the entire US) was due, in large part, to the nearly confiscatory taxes on capital gains on land sales so that the high land valuation was based on virtually NO sales. When the Japanese tried to correct this tax distortion by lowering the capital gains tax rate, sellers rushed to the market and land prices collapsed… There is nothing irrational about this and real estate economists predicted the collapse as they did with US real estate prices.
As to the current state of depository institutions and mortgage markets in the US… are bankers irrational for taking substantial risks in real estate lending? Given that deposit liabilities are guaranteed and bank examiners allow the risk taking, one can easily argue that the behavior of bankers was fully rational. The recent book on the Lehman bankruptcy makes it clear that the economist in charge of risk management informed top management of the problems in mortgage markets in a timely fashion. They ignored her (actually demoted her to government relations) relying on the belief that they were two big to fail. Unfortunately for them, Hank Paulson was not sympathetic. This is an error in judgment ex post but before the fact, there were rational reasons to believe that they would be treated like GS, BOA, Citi, etc.