Currency Wars_ The Making of the Next Global Crisis - James Rickards [99]
Financial Economics
At about the same time that Paul Samuelson and others were developing their Keynesian theories, another group of economists were developing a theory of capital markets. From the faculties of Yale, MIT and the University of Chicago came a torrent of carefully reasoned academic papers by future Nobel Prize winners such as Harry Markowitz, Merton Miller, William Sharpe and James Tobin. Their papers, published in the 1950s and 1960s, argued that investors cannot beat the market on a consistent basis and that a diversified portfolio that broadly tracks the market will produce the best results over time. A decade later, a younger generation of academics, including Myron Scholes, Robert C. Merton (son of famed sociologist Robert K. Merton) and Fischer Black, came forward with new theories on the pricing of options, opening the door to the explosive growth of financial futures and other derivatives contracts ever since. The work of these and other scholars, accumulated over fifty years and continuing today, constitutes the branch of economic science known as financial economics.
University biologists working with infectious viruses have airtight facilities to ensure that the objects of their study do not escape from the laboratory and damage the population at large. Unfortunately, no such safeguards are imposed on economics departments. For every brilliant insight there are some dangerous misconceptions that have infected the world’s financial bloodstream and caused incalculable harm. None of these ideas has done more harm than the twin toxins of financial economics known as “efficient markets” and the “normal distribution of risk.”
The idea behind the efficient market is that investors are solely interested in maximizing their wealth and will respond in a rational manner to price signals and new information. The theory assumes that when material new information arrives it is factored into prices immediately, so that prices move smoothly from one level to another based on the news. Since the markets efficiently price in all of this new information immediately, no investor can beat the market except by pure luck, because any information that an investor might want to use to make an investment decision is already reflected in the market price. Since the next piece of new information is unknowable in advance, future price movements are unpredictable and random.
The idea of normally distributed risk is that since future price movements are random, the severity and frequency of price swings will also be random, like a coin toss or roll of the dice. Mild events happen frequently and extreme events happen infrequently. When the frequent mild events and infrequent severe events are put on a graph, it takes the shape of the famous bell curve. The large majority of outcomes are bunched in the area of low severity, with far fewer events in the high severity region. Because the curve tails off steeply, highly extreme events are so rare as to be almost impossible.
In Figure 1 below, the height of the curve shows how often events happen and the width of the curve shows how severe they are, either positive or negative. The area centered on 0 traces those mild events that happen frequently. Consider the area of the curve beyond −3 and +3 This area represents events of much greater severity, events like stock market crashes or the bursting of housing bubbles. Yet, according to this