21 December 2009

When Darwin meets Smith

The Great Recession has discredited the once-irreproachable efficient-markets hypothesis (EMH). It turns out after all that markets do not present all available information, that investors and consumers are not always rational agents, and that prices fluctuate with alarming frequency and wide variation. In the ‘Issues 2010’ special edition of Newsweek, Barrett Sheridan ('Markets are like people') reports on a proposed alternative to the EMH; the adaptive-markets hypothesis (AMH). This idea’s foremost proponent is MIT economist Andrew Lo, who has set out to repair the now-obvious flaws of the EMH using the findings of behavioural economics. More specifically, Lo wants to introduce Adam Smith to Charles Darwin.

Lo, who presented the AMH idea in 2004, draws an analogy between evolutionary biology and economics. Sheridan writes:

[Lo’s] theory builds on the work of [Nobel Laureate economist Joseph] Stiglitz and others, and can be explained simply enough; the economy and financial markets are an ecosystem, with different “species” (hedge funds, investment banks) vying for “natural resources” (profits). These species adapt to one another, but also go through periods of sudden mutations (read: crises).

And natural selection will result in some species flourishing while others – like Lehman Brothers – die out.

Since the AMH is predicated on the irrationality of markets, this raises the question: how do we then predict a bubble or the next global crisis? Lo believes that “the secret lies in studying the “ecology” of the markets. Just as biologists catalogue species and chart their fortunes over time, regulators and policymakers should categorise the market’s many players.” And track their actions over time in various settings. Apparently such information isn’t collected because according to the old EMH doctrine, “everyone responds to incentives in the same basic way.” But the adaptive-markets hypothesis takes into account the reality of irrational participants behaving in different, unpredictable ways. While achieving absolute certainty is impossible, extensive data on the various economic species will make detecting and interpreting patterns more accurate.

One hiccup though – perhaps a theory-killing one – is the reluctance of investors and consumers to provide the required information; the former may understandably refuse to reveal their investment strategies, while the latter may decline to discuss their spending habits. Unlike plants, birds and Patagonian armadillos, people are rather cagey when it comes to divulging information about themselves. And presumably not many would agree to be the subject of detailed, invasive observation over several months, or years. Any attempt to assemble a database that will allow a practical application of the AMH will need to address the basic human right to privacy. After all, Darwin didn’t have to deal with Galapagos tortoises telling him, “Look, we get that you find us terribly interesting, but would you kindly fuck off.”

But let’s not be discouraged. It’s obvious that the efficient-markets hypothesis – which has dominated economic and political thought for the last thirty-odd years – is in serious need of revision, if not total abandonment. Andrew Lo’s suggested replacement has, if nothing else, the virtue of acknowledging the irrational nature of markets and their participants. And it can’t hurt to apply the principles of a discipline as rigorous and methodical as evolutionary biology to the more fuzzy one of economics. To paraphrase the psychologist Steven Pinker, the different departments in a university do not reflect meaningful divisions of knowledge. All disciplines – scientific and humanistic – are intertwined, their compartmentalisation being merely for human convenience.

In The Wealth of Nations, Adam Smith famously wrote that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.” And that self-interest can often be myopic, greedy and irrational, with disastrous consequences. Any grand theory that ignores this fact should be naturally deselected. Post haste.


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