Irrational Markets Jude Wanniski October 20, 1998

Memo To: Alan Murray, WSJournal Washington bureau chief
From: Jude Wanniski
Re: Monday's "Outlook" column

Your observations in Monday's page one "Outlook" column on the zany swings in the world financial markets in the last few years rests on the observation that markets are basically irrational and can be easily driven by fear and hope: "From David Ricardo at the beginning of the 19th century to Myron Scholes and Robert Merton at the end of the 20th, economists have built elaborate mathematical models on the breathtakingly faulty assumption that human beings behave rationally. Oh, sure, we humans have our moments. The ability to reason distinguishes us from squirrel monkeys. But the ability of irrational hope and fear to overwhelm reason is what makes life interesting — and economics unreliable."

I know what you are trying to say, Alan, but the way it comes across is that you don't know what the heck is going on. The market must be irrational if you don't understand it. It certainly must be irrational if Scholes and Merton have impoverished themselves and the Long-Term Capital clients by applying their Nobel Prize work to the real world. It sounds as if you were saying that if their prizes in economics were any good, they would become extremely wealthy. That's not what people mean when they say the market is rational, Alan.

After all these years, I'm surprised you still don't know why markets behave rationally when they swing wildly up and down and also behave rationally when they are steady. Economics is unreliable when its underlying principles are wrong. Greenspan introduced the concept of "irrational exuberance" because he could not explain the enthusiasm of the equity markets in his personal analytical framework. The market is comprised of everyone in the market and everyone who is not in the market, but might get in and might stay out, based on the available information. Many people who have made money over a stretch of years by playing the market come to think the market stands still, and will yield profits when played the same way. Like George Soros, they get burned because the reason they made money in the first place was because of a lucky coincidence of their faulty model with the assessments of the overall market. People who "beat the market" over  the years are those who are constantly studying the market, hoping to be in the front rank of purchases and sales. There are also people who beat the horses over the years by matching their estimates to the estimates of the tote board. Is the tote board irrational?

Because you don't play the market, you don't learn its harsh lessons. Greenspan is in a more difficult position, because he caused the monetary deflation that produced such chaos in the world. He thus is forced to argue that the market sometimes becomes irrational, as when he does not understand why it is not acting the way he expected it to act. Greenspan still thinks the 1987 crash was a "bubble," but I have reminded him he should not have given an interview to Fortune in October 1987, in which Sylvia Nasar said he believed the dollar would have to devalue against the yen for several years. The interview helped blow up the market's understanding that there was an accord among the major players, "the Louvre Accord," that exchange rates would be stabilized. Thus, Greenspan helped James Baker III burst the "bubble." Was it irrational for the market not to realize Greenspan would give the interview and that JBIII would reverse himself on the Louvre Accord, both on the same weekend? If you are to be a serious analyst of the financial markets, you should ask for reassignment, from Washington to New York.

When you cited David Ricardo's arguments on behalf of rational markets in the early part of the 19th century, you did not exactly leave the impression that you had read him. I suggest you read his Principles of Political Economy, and you will get a clearer sense of what he was driving at. You also can go back further, to Aristotle's Politics and realize how even then philosophers saw bulls and bears canceling each other out, with the final outcome made on the margin by the tie-breaker. You also should read Ibn Khaldun, the 14th century philosopher who Reagan loved to quote, who understood the concept of a regression to the mean. You of course are right that most people are "sheep" who run in herds, but you should ignore this fact in understanding a market's efficiency. In a small market of three people, the trend-setter can persuade the sheep to herd in his direction. Remember Tom Sawyer persuading the kids how much fun it was to whitewash the fence? When the market gets as large as the world economy, that kind of action no longer works.

You are a brave bureau chief, Alan, to post your idle thoughts on the front page of the Journal when you seem to know so little about your subject. I admire your grit. If you would like, I'll send you a few pieces I did in recent years, "Thinking About Markets," which might help. It's not out of the question that you may get transferred to Wall Street someday, and will need to know more about efficient market theory and rational expectations. In brief: All of us are dumb, individually, but collectively we are superior to any one of us. At the margin, in a market each one of us counts as much as everyone else, but some of us are more reliable at picking winners than others.