Justin Fox, Fischer Black, Tyler Cowen
By Arnold Kling
Fox, The Curious Capitalist, has a new book, called The Myth of the Rational Market. He spent a lot of time trying to piece together the history of the theory of efficient financial markets–random walks, capital asset pricing model, option pricing formula, on the one hand, and noise trading and behavioral finance on the other. I’ll excerpt a few paragraphs below.
One of the characters in Fox’s book is Fischer Black, who often wrote for the Financial Analysts Journal. Tyler Cowen has an article in that journal, in which he claims to be using Black’s ideas to explain the financial crisis.
You have to read the whole thing. I get the sense that Tyler had this tremendous stream of thoughts, but he only wrote down a few excerpts. To quote from the paper is to take an excerpt of an excerpt, as it were. For example,
As investors pull their resources out of risky assets, the prices of those assets reflect less and less market information and markets become less efficient.
He just tosses that in there, and I am not sure (a) whether it is right or (b) whether it is important to his central thesis.
His central thesis, as I see it, is this:
1. A lot of wealth was created in the 1990’s, particularly in rapidly developing countries.
2. People felt inclined to take risks with this new wealth, and they felt inclined to trust others to select the risks to take.
3. The risk-taking became excessive, and we had a crash.
4. Now, there is a big mess, and there is not much anyone can do about it.
I am trying to sort out the issue of operating leverage vs. financial leverage. I always thought that Fischer Black’s story of the business cycle was one of operating leverage. People acquired too much human capital and physical capital, which in an efficient market has a high beta, meaning that its value depends on a common factor driving the economy.
Think of an agricultural economy in which investments will pay off really well if there is good weather, but lose badly if there is bad weather. If people are cautious, they will not invest a lot and instead will hold safer assets (maybe just grain stored in silos). If they are less cautious, they will buy lots of tractors and get degrees in agronomy. If the weather turns out bad, they would have been better off just storing grain.
Financial leverage means that financial institutions take on a fragile financial structure. Our farmers don’t necessarily overinvest in tractors and agronomy degrees. But when they do invest, they take on debts, and the banks that lend to them hold very little capital.
Clearly, it is easier to get overinvestment if there is a lot of financial leverage. And if the financial sector is deleveraging, then it is easy to get underinvestment. But my recollection of Fischer Black is that he was more focused on what I call operating leverage, not financial leverage.
Here is an excerpt from the conclusion of Fox’s book (p. 307):
For figuring out what your portfolio should look like, Harry Markowitz’s model of balancing risk and reward–and looking for investments that aren’t correlated with each other–remains an excellent starting point. The complication is that it’s not past volatility and past correlations that determine investing success, but future volatility and correlations. That future can only be guessed…
A popular concept in recent years has been the “wisdom of crowds”–the notion that groups can often make better-informed decisions than individuals. It’s a valid enough idea, and the title of an excellent book by James Surowiecke, but the wording is misleading. Crowds–and markets–possess many useful traits. Wisdom is not one of them…
Markets, as Friedrich Hayek argued, are the best aggregators of information known to ma. Yet mixed up amid the information in security prices is an awful lot of emotion, error, and noise.