Another shoe has dropped with the exposure of the Bernard Madoff fraud, in which an investment manager is said to have bilked investors out of $50 billion in a massive Ponzi scheme.
This criminal fiasco poses fundamental questions about how human nature contributes to the extremes of the business cycle we call booms and busts.
After the collapse of major investment banks like Bear Stearns and Lehman Bros., the emergency bailout of insurer AIG and other problems in large financial companies, it seemed inevitable that some large fund would blow up.
That a fund failure would stem from a Ponzi scheme was not expected, given that there are a lot of nonfraudulent ways in which these funds have been able to lose money. And there may yet be other disasters.
But for now, the Madoff scandal is the center of news. And it illuminates a debate that has occupied economists for four decades on the extent to which markets are “efficient.”
That is, to what extent do the buyers and sellers of financial assets act rationally in deciding at what price they are willing to buy or sell a stock, bond, option, futures contract or other financial instrument? If people reason their way to such decisions, then the market prices of securities accurately capture their true value, based on all information available.
This implies there are no opportunities for anyone to consistently outperform the market, except by luck. It is simply impossible for someone like Madoff to consistently have higher returns than the market as a whole, quarter after quarter, year after year.
Indeed, such belief in efficient markets is at the core of why Madoff’s reported performance apparently raised eyebrows among many on Wall Street. It even led several to alert the Securities and Exchange Commission that something was rotten.
If investors believed in the efficient market hypothesis and were rational, they would have reached the same conclusion. They would have said “something is wrong here” and would have stayed away. Reportedly, some did.
But many others grabbed at the chance. Their behavior conforms to the ideas of a newer school of thought called “behavioral finance,” which challenges the idea of efficient markets.
Since the late 1800s, economics emulated Newtonian physics, in which different forces interacted to reach a predictable equilibrium. Behavioral economists instead align themselves with modern psychology, especially cognition.
They argue that individuals misperceive reality through overconfidence and overreaction to new developments. They are influenced by the views and actions of others, and so on.
While some investors stayed away from Madoff because his reported performance was too good to be true, others maneuvered to get him to take their money. Often they were motivated by reports from friends or colleagues who had money in Madoff’s fund and thought the returns were well above other alternatives.
The actions of individual investors with Madoff clearly support the behavioral finance school.
But what about applying it to the broader question of the financial market bubble that has just popped?
Efficient-market theory does not explain bubbles very well. If people had been rational looking forward, many would have seen the flaws in the belief that housing prices would never fall, that mortgages made to people with poor repayment ability could somehow be packaged into safe securities, that dramatic increases in household indebtedness posed no risk, or even that one could make the money supply grow twice as fast as the economy without that excess liquidity popping its ugly head up somewhere.
Indeed, individuals here and there did point out what now clearly seems folly. But their voices were drowned out in the clamor of a building and consumption boom. Like duffers in a country club locker room listening to their friends’ reports of Bernie’s magic touch, we collectively concluded that if it was working for everyone else, it should work for us.
Economic bubbles are fun. We enjoyed the giddy feeling of seeing our houses appreciate in value along with our 401(k)s. Now, like those who trusted their fortunes to Madoff, we all need to deal with the consequences of our irrationality.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.