The myths of the rational investor and the efficient market hypothesis have much to answer for. Arguably, they underpinned the folly that was Alan Greenspan-ism, fuelling the insanity that overcame banking and financial markets ahead of the global financial crisis.
I’ve always thought there are parallels between neo-liberal economists who peddled such thinking and indeed managed to make it mainstream for more than two decades, and the inhabitants of the mythical floating island Laputa in Jonathan Swift’s Gulliver’s Travels.
The erudite Laputans spend their days working on obscure mathematical, astronomical, musical and technological theories -- but remain resoulutely incapable of putting these to any practical use.
A new book by David Tuckett, Minding the Markets, builds on these themes. The author, a professor at University College London who trained as an economist before focusing on sociology and psychoanalysis, argues that contemporary economics is a pseudoscience. This is because it ignores the emotions and unconscious fantasies that drive human behavior. You can watch a short lecture by Tuckett here:
The book will make uncomfortable reading for academic (and indeed non-academic) economists, many of whom still cling to neo-classical nostrums, even though their faith is built on flawed mathematical models and the assumption that investors behave rationally.
Writing in The Observer, Heather Stewart provides an excellent synopsis of Tuckett’s thinking (which is so well-written I’ve taken the liberty of quoting it at length):
"There is plenty of economic research – by George Akerlof and Robert Shiller, for example – on the psychology of market bubbles. But Tuckett's insight, based on in-depth interviews with more than 50 investors, each managing more than $1bn, is that stocks, shares and derivatives are a special kind of asset, and decisions about whether to buy and sell them are particularly subject to stories and emotions.
"For one thing, the value of financial assets is prone to extreme uncertainty: thousands of unpredictable events can affect the profitability of a company, for example, from the collapse of a key supplier to a sudden change in the cost of commodities to a natural disaster many thousands of miles away.
"At the same time, the owner of a share – or a credit default swap – has nothing they can eat, drink, live in, or even hold in their hands: they have to weave a story, a narrative, even to understand why it's worth buying the asset in the first place, let alone hanging onto it when its value has soared to once-unthinkable heights.
"Given these special characteristics, Tuckett argues, financial assets tend to become what he calls 'phantastic objects', which their owners invest with extraordinary powers and think about in ways that are unavoidably emotional.
"Subconsciously, investors suppress nagging, negative thoughts (How can this firm possibly be worth that much? What if US house prices don't go up for ever?) and plough on in what psychoanalysts call a 'divided state'."
Tuckett's core argument is that the short-termist culture in today's financial markets promotes irrational thinking amongst investors -- including a proclivity to depend on self-serving fairy tales instead of facts. It also encourages investors to suppress negative emotions they may have about risk. The recent Groupon IPO is perhaps an excellent illustration of the sort of groupthink that can sometimes end in disaster.
Tuckett believes that investors actually fall in love with the stocks they own, to the extent that they become irrational and blind to their flaws. When their love wanes, they tend to over-react by accentuating the negative, with their love turning rapidly into out-and-out hatred. As Stewart says:
"The traders piling into tulips, credit default swaps or gold ingots are carried along by a collective frenzy of hopes, fears and anxieties – what Tuckett calls 'groupfeel'. As he points out, even regulators, and watchdogs such as the IMF, were caught up in the maelstrom, soothed by the idea that financial innovation had made the world a safer place – and reluctant to be the cause of the pain that would result from pricking the bubble."
Further reading on the failures of classical economic and the role of emotion in financial markets:
- Viewpoint: Justin Fox In Praise of Decisive Action
- Viewpoint: Richard A. Werner Why the Mainstream Paradigm in Economics and Finance Collapsed
- Fear, Rage and Bad Decisions by Bill Sharon
- Kotlikoff: financial system is a Ponzi scheme that could collapse at any time by Ian Fraser
Tags: Alan Greenspan , asset price bubbles , behavioral economics , David Tuckett , fund management , George Akerlof , Greenspan-ism , Groupon , Gulliver's Travels , Heather Stewart , Jonathan Swift , real economy , regulation , Robert Shiller , stocks and shares , The Observer , University College London