The Story So Far: Greed + Incompetence + A Belief in Market Efficiency = Disaster

«Greed and reckless overconfidence on the part of almost everyone caused us to ignore risk to a degree that is probably unparalleled in breadth and depth in American history. Even more remarkable was the lack of insight and basic competence of our leadership, which led them to ignore this development, or worse, to encourage it. Ingenious new financial instruments certainly facilitated and exaggerated these weaknesses, but they were not the most potent ingredient in our toxic stew. That honor goes to the economic establishment for building over many decades a belief in rational expectations: reasonable, economically-induced behavior that would always guarantee approximately efficient markets. In their desire for mathematical order and elegant models, the economic establishment played down the inconveniently large role of bad behavior, career risk management, and flat-out bursts of irrationality.

The dominant economic theorists so valued orderliness and rationality that they actually grew to believe it, and this false conviction became increasingly dangerous. It was why Greenspan and Bernanke were not sure that bubbles – outbursts of serious irrationality – could even exist. It was why Bernanke, who had studied the bubble of 1929, could still not see it as proof of irrationality and could still view the Depression (à la Milton Friedman) as a mere consequence of incredibly bad, easily avoidable policy measures.

Of more recent importance, it was why Bernanke could dismiss a dangerous 100-year bubble in U.S. housing as being nonexistent. It was why Hyman Minsky was marginalized as an economist despite his brilliant insight of the “near inevitability” of periodic financial crises. It was why the suggestion in academic circles of stock market inefficiencies, let alone major dysfunctionality, was considered a heresy. It was why Burton Malkiel could rationalize the 1987 crash as being an efficient response to 12 or so triggers. These triggers, however, had a trivial weakness: seasoned portfolio managers at the time had never even heard of most of them. Never underestimate the power of a dominant academic idea to choke off competing ideas, and never underestimate the unwillingness of academics to change their views in the face of evidence. They have decades of their research and their academic standing to defend.

The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and governmental establishment sitting by confi dently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. “Surely none of this could happen in a rational, effi cient world,” they seemed to be thinking. And the absolutely worst aspect of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking – the very severe loss of perceived wealth and the stranded debt that comes with a savage write-down of assets. Well, it’s nice to get that off my chest once again!».

GMO QUARTERLY LETTER January 2009