Business Books: When rational market models go awry

NEW YORK, June 18 - The idea that markets behave rationally, which has dominated economic discourse for half a century, took a big hit in last year's credit crisis.

If markets were efficient, the argument goes, housing prices would not have grown into a bubble.

In reality, U.S. and European governments must now factor the vagaries of investor sentiment into their attempts at new regulations for financial markets.

Justin Fox, an economics columnist for Time Magazine, lays out these arguments in his book, "The Myth of the Rational Market" (Harper Business, $27.99).

The best known element of rational market theory is the efficient market hypothesis, which states that prices reflect all the known information about an asset.

Fox chronicles its rise at the University of Chicago in the 1960s, and its far-reaching impact on U.S. policies from setting interest rates to industry deregulation.

"I think in most cases the people who came up with the theories saw them for what they were, imperfect models of reality," Fox told Reuters. "But later on, some of them ended up being treated as eternal truths."

Fox's populates his book with both adherents of rational market theories, like Milton Friedman and Paul Samuelson, and detractors, such as Joseph Stiglitz and White House economic adviser Lawrence Summers.

On one hand, the evolution of this philosophy, along with computer advances, created such investments as index mutual funds that brought Wall Street to the masses.

On the other hand, they bred complex products like collateral debt obligations and total return swaps, which failed spectacularly in their promise to provide stable returns with minimum risk.

During the U.S. housing boom, these financial vehicles, coupled with low interest rates, led to loans to people who would not have been able to afford to borrow conventionally.

"DANGEROUSLY UNSTABLE"

"Sustained good times inevitably bring financial practices that are dangerously unstable," Fox writes.

Investors assumed that bonds backed by mortgages would continually provide strong returns to investors with minimal risk.

When the housing bubble burst in the summer of 2006, sending nationwide home prices falling for the first time in decades, a record wave of home foreclosures and loan defaults resulted, which in turn made billions of mortgage securities owned by banks, hedge funds and pension funds worthless.

The mortgage debacle has devastated the global economy. In the United States alone, household net worth dropped to $50.4 trillion in the first quarter, $12 trillion less than in 2007 when the housing boom peaked, according to Federal Reserve data.

Even the most ardent supporters of rational market theories have admitted its shortcomings, according to Fox.

"The mathematics of financial models can be applied precisely, but the models are not at all precise in their application to the complex real world," economist Robert Merton said when he accepted the Nobel Prize for economics in 1997.

Merton shared the prize with Myron Scholes for creating, along with Fischer Black, a model for pricing options that has since became a pillar of modern finance. Merton and Scholes were also part of Long Term Capital Management, the big hedge fund that collapsed a year later.

Rational market theories and models, while best used for a long-term view, are deficient as financial tools in the current post-crisis environment, Fox said.

"Given that they're of almost no help whatsoever in explaining financial crises," Fox said, "I certainly wouldn't call them the best overview at a time like this."