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Smack Down September 21, 2009

Posted by Dwight Furrow in Dwight Furrow's Posts, Political Philosophy, Science.
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In the wake of the on-going financial crisis, the field of macroeconomics has been embroiled in its own crisis. Critics such as Paul Krugman have argued that the inability of macroeconomics to recognize the dangers of the real estate bubble and the precarious position of the banking system calls into question the reigning models of how economies work and undermines the claim that economics is a predictive science.

The reigning model for the past few decades has been the “efficient markets hypothesis” (EMH) which asserts (roughly) that, because economic actors are rational and self-interested, markets tend to establish the correct prices for goods. Poor decision making in this regard will be punished by competitive pressures and the market will inevitably return to equilibrium.

This of course leads to the conclusion that government should not regulate or intervene in markets because such interference disrupts the “natural” price setting mechanisms.

Some of us philosophers have suspected for many years that EMH is nonsense—we know that human beings are neither rational nor (always) self-interested and that information is seldom sufficiently available to make fully informed decisions.

But we are philosophers noted for our lack of practical knowledge and no one pays attention to us.

But now that the financial crisis has shown that the emperor has no clothes evidence that EMH is false should be overwhelming. However, this has not stopped the defenders of EMH from pushing back against their critics.

At any rate, a former professor of mine, Alex Rosenberg who is widely published in the philosophy of science and the philosophy of economics, recently wrote a devastating critique of EMH which has been posted at Leiter Reports.

Here is the key point:

The first thing a philosopher notes about this notion is that since most people have false beliefs, especially about the future, an efficient market doesn’t internalize knowledge, but only beliefs. If they are mostly false, then the market isn’t efficient at internalizing (correct) information, it’s efficient at internalizing mostly false beliefs. If false beliefs are normally distributed around the truth, then they’ll cancel out and the proof of a probabilistic version of the efficient markets theorem will go through—market prices reflect the truth most of the time. Too bad false beliefs don’t always take on this tractable distribution. Even worse, when enough people notice the skewed distribution of false beliefs, they can make rents, as the markets crash.

There are an infinite number of ways human beings can be irrational, and given the herd mentality of the financial markets, forming a consensus around false beliefs can seriously lead us astray.

It may be true that in the long run the market will get around to correcting itself when enough people recognize their mistake, but as John Maynard Keynes so aptly noted, in the long run we are all dead.

The entire blog post and comments are worth checking out.

book-section-book-cover2 Dwight Furrow is author of

Reviving the Left: The Need to Restore Liberal Values in America

For political commentary by Dwight Furrow visit: www.revivingliberalism.com