Deconstructing Financial Crisis

The Myth of the Rational Market, Justin Fox, Harper Business, pp. 340

Justin Fox is the editorial director of the Harvard Business Review Group and a contributor to Time magazine. In this fascinating historical narrative of the financial crisis of 2008 and the events leading up to it, Fox dissects ideas, people and their behavior. The perception of risk and the belief in market rationality is part of both economic thought and cultural history that consolidated the modern world of finance and investment. What the financial crisis did was, not only demolish fortunes, but also ideas put forth by intellectuals who battled to bring in a particular brand of capitalism.

Tracing history

The book is divided into five parts. This section-wise division elaborates the timeline leading up to the financial crisis. In the beginning of the twentieth century, it was unusual to associate the idea of market with rationality. The first serious attempt to apply the logic and reason of science into economics began with Irving Fischer. In his time, the idea that man was infinitely selfish and infinitely far sighted prevailed. Fischer took this assumption by the horns and argued that the uncertainty of the future could be ‘tamed’, if not eliminated. This was the beginning of modeling the future outcomes with variables available in the present.

Fischer’s work was taken a step forward by Harry Markowitz, who introduced the ‘statistical man’ to the market with the help of quantitative approach to investing. The world events of the time prepared such intellectual pursuit because of the emergence of strategic thinking in the Second World War. About a decade later, it was Paul Samuelson, who wrenched the idea of rational market that was on the fringes of the economic thought into the centre stage of academic research. Samuelson, who was in the habit of reading every paper that was published in the Quarterly Journal of Economics, came across the idea of ‘market randomness’. In a case of remarkable serendipity, a doctoral thesis of Henry Bechelier filled with dense description of market behavior caught his attention. He immediately recognized that the randomness of market mathematically described was similar to what Albert Einstein described about the Brownian motion of random particles. This paved the way for the belief in the market as rational and random.

Age of Assumptions

      The decades that followed were notable for two major achievements. Modigliani and Miller came up with a simplifying assumption that argued that the market behaves only based on real considerations of how an investment would actually perform, and not on the packaging of the investment. Eugene Fama, a doctoral student of the Chicago school, proposed that the investor’s choice took random positions along a bell curve. The metamorphosis of the market from being rational to random and from there to being perfect was established. It was this cherished belief that was shattered in the financial crisis of 2008. Alan Greenspan, the chief of the Federal Reserve for 14 years admitted that the economists failed to anticipate the crisis and invite government intervention because ‘it (the market) has been working exceptionally so well’.

This book is an engrossing read that pays rich tribute to well-known and lesser acknowledged economists and thinkers of the twentieth century. The history of ‘risk and reward’ that the book captures brings out a lively account of the protagonists in the financial world and the anatomy of the financial markets.