Opinion of the court, delivered by Nicole Adams, signed by David Lamb
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.
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 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 in and just out of bankruptcy court, 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, 7%, 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.
William Leich, Dissenting:
In truth, the bubbles of the last decade aren’t evidence that the market efficiency no longer applies to investing. Rather, it applies more than ever; the availability of information has brought the EMH closer to reality.
And as the acceleration of information helps businessmen and investors make better decisions at both ends of the business cycle, regulation becomes a necessity at both ends.
Now, when over 9.4% of Americans are unemployed, Mr Obama and his Congress have the political mandate to re-regulate the financial system. They ought to embrace this opportunity to pass permanent caps on executive pay—albeit with a cost-of-living adjustment—and tighten rules on asset leveraging, short selling stocks, and trading credit derivatives like credit-default swaps.
The latter three of those financial practices export risk from the party engaging in them to the broader system as a result of bankruptcy laws. Of course, where such negative externalities exist, people will exploit them until forced to stop. The federal government could regulate the practices either through higher required reserve ratios or by taxing them.
Either way, regulation needs to be imposed to discourage individuals participating in systemic risk-taking. This is regulation that can’t wait for the next recession or the next depression. Whether or not Mr Obama believes in the EMH, he ought to believe in a certain number: it’s 5,800, the number of points the Dow Jones Industrial Average has fallen since October of 2007. That’s the price America paid for under-regulation.
On Regulating Finance
Opinion of the court, delivered by Nicole Adams, signed by David Lamb
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.
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 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 in and just out of bankruptcy court, 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, 7%, 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.
William Leich, Dissenting:
In truth, bubbles of the last decade aren’t evidence that the market efficiency no longer applies to investing. Rather, it applies more than ever; the availability of information has brought the EMH closer to reality.
And as the acceleration of information helps businessmen and investors make better decisions at both ends of the business cycle, regulation becomes a necessity at both ends.
Now, when over 9.4% of Americans are unemployed, Mr Obama and his Congress have the political mandate to re-regulate the financial system. They ought to embrace this opportunity to pass permanent caps on executive pay—albeit with a cost-of-living adjustment—and tighten rules on asset leveraging, short selling stocks, and trading credit derivatives like credit-default swaps.
The latter three of those financial practices, as a result of bankruptcy laws, export risk from the party engaging in them to the broader system. Of course, where such negative externalities exist, people will exploit them until forced to stop. The federal government could regulate the practices either through higher required reserve ratios or by taxing them.
Either way, regulation needs to be imposed to discourage individuals participating in systemic risk-taking. This is regulation that can’t wait for the next recession or the next depression. Whether or not Mr Obama believes in the EMH, he ought to believe in a certain number: it’s 5,800, the number of points the Dow Jones Industrial Average has fallen since October of 2007. That’s the price America paid for under-regulation.
I have to agree that I do think we are finally learning how to manage our money better and I think the recession has a lot to do with that. While it might seem like all doom and gloom there’s quite a lot of good coming out of it – I’ve met a lot of people who 2 years ago couldn’t afford a house – but now they can.
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It’s true that regulation is needed most during good economic times, but the reality is that regulation is _wanted_ least at those times. Mustering the political momentum to pass such regulations (or at least to prevent them being gutted) requires that economic hardship refocuses America’s attention on the importance of establishing and maintaining a valid set of ground rules. Now is the time to move on re-creating the protections that were lost in the ‘rosy glasses’ times gone by, so that we’ll have them in place for the next major financial plunge.