The Price of Everything - Eduardo Porter [112]
Every time investors become enthusiastic about some new investment proposition, they assure us that this time will be different. During the dot-com bubble the surge of productivity enabled by information technology allowed us to believe that the historical moment was unique. During the housing boom, we were sure that high-tech financial engineering would protect us from financial risks, spreading them among investors who knew how to handle them. Each time the Pollyannas were wrong.
WHAT RATIONALITY?
Interestingly, there are economists—prominent ones—who believe bubbles don’t exist. Indeed, during the past four decades the prevailing view among many if not most economists was that prices could never be wrong. The insight that prices set in a free exchange between willing buyers and sellers can allocate resources to where they would be most profitably used somehow transformed into a blind belief in the infallibility of markets. According to this model of reality, processes that took prices way above their reasonable, true value, luring people into big mistakes, could not possibly exist.
The seeds of this ideology were laid in nineteenth-century Vienna before settling in the middle of the twentieth at the University of Chicago, perhaps the most influential school of economics of the last thirty years. It held that the free market was the only legitimate way to organize society because it started with individuals’ free will. Markets would organize the world impeccably by assigning relative values to goods, services, and individual courses of action. Humans being rational—meaning that they had a consistent set of preferences and beliefs about how their choices would improve their well-being—their decisions had to be the right ones. Government intervention, imposing the will of the state upon the people it ruled, was in this view necessarily inefficient and wrong.
To be sure, the so-called rational actor model has been enormously powerful in understanding people’s choices. Its simple core idea, that we set out to maximize our well-being, provides a convincing immediate explanation of people’s behavior. And it meshes with our understanding of the evolutionary processes shaping the development of species: if each decision we make leads to a set of probable outcomes with different odds of genetic survival, natural selection would shape preferences in such a way as to maximize biological fitness. But our faith in this theory went much too far. In the 1970s, the rational actor model was extended into the theory of “rational expectations.” This adapted the belief in humanity’s rationality to the fact that we cannot predict the future and thus must make decisions based only on what we expect the consequences of our actions will be, fitting the probable outcomes of our choices to our set of preferences. For instance, it posits that we plan our lives by coolly estimating our likely future income paths, adjusting our savings accordingly in order to smooth our consumption through our entire lifetimes—consuming less during our peak earning years in order to be able to consume more in retirement.
This was a perfect perch for a theory of perfect prices to latch on to. It posited that the price at which rational people would trade an asset, like orange juice futures, would reflect the available information affecting the asset, such as the weather and its impact on the orange crop. If a set of unusual expectations led a group of investors to push prices away from this rational path, the other investors in the market would make money by betting against them and bring prices back to reason. Economists called this the hypothesis of “efficient markets.” These views reached their zenith in the 1980s, after Ronald Reagan and Margaret Thatcher rose to power in the United States and Britain amid