David Kuo is joined by author, journalist and columnist Justin Fox.
You can download or listen to this podcast here.
David:
This is MoneyTalk, the weekly investing podcast from the Motley Fool. I'm David Kuo, and today we will be looking at whether the market is always right, and if the market is always right, why did it not see the crash of 2007? Now here to pour a jug of cold water over the efficient market theory is journalist and columnist, Justin Fox, who is the author of The Myth of the Rational Market. Welcome to the Motley Fool, Justin.
Justin:
Thanks so much for having me, David.
David:
I tell you what, this book is just absolutely amazing, and I recommend anybody who is even vaguely interested in what has gone on over the last couple of years or so to read this book, and it will open your eyes completely. Now, can I also say that I agree whole-heartedly with the New York Times, when they said your book is a must-read, it has created a new dimension, as far as I'm concerned, to economics that I didn't think possible, it has made economics interesting and accessible to everyone.
But I'd like to start at the very very beginning, Justin, and this is back in Manchester 1833, when the Manchester Statistical Society, a group of businessmen, sat together and pondered the causes of the business cycles. Now, what exactly did they find, Justin?
Justin:
Well, first of all, the reason they were doing it is, we had two bubbles, and the South Sea bubble, and things like that, before the early 1800s, but it was really in the early 1800s in England that you started having this regular cycle of boom and then panic and then bust, and the first thing they found is that gee, these things seemed to happen every eleven or twelve years, because that's what was happening in the early 1800s, and then they started wondering, hmm, wonder why that is, and one of the members, John Mills, a banker and poet, he came up with a really nice explanation that's actually very similar to what you'll hear from a lot of smart market observers now, which sort of has to do with different generations, and people forgetting the experience of a crash, and so basically after a crash you'll have this group of grizzled veterans who are very aware of risk, and very scared, and the market sort of just hobbles along, but then at a certain point they start retiring, younger people come in who haven't been through that experience, and you reach this point, and in his telling it's only after seven or eight years, I don't know if that's right, but you reach a point where the people who don't remember the last crash, or have expunged it from their memory, are suddenly dominating the market, and then you basically go the races again.
David:
But why didn't people at the time just leave well enough alone? I mean, they had a reasonable explanation for what goes on with business cycles, in other words, it's a kind of emotional thing, you get very euphoric about an investment, and then you suddenly think, well, maybe it isn't so good after all, then panic sets in, and that was fine. So tell me about this guy called William Stanley Jevons, and his eleven-year cycle of spots on the sun -- how did he relate that to the business cycles?
Justin:
Jevons was one of the great economists of the 19th century, a great innovator, and the economics that he worked in, he was one of the early mathematical economists, relied on people rationally trying to maximise their wealth, and so any explanation that was all about emotions and such, it just left him a little bit cold, and so he looked for another explanation, and studied crop records and all sorts of other things, and finally decided that it was the sunspot cycle, and he had this bizarre convoluted explanation that the sunspot cycle, because it affected through the crops in India, then had these knock on effects that eventually caused booms and bust in the West.
David:
But the thing is, recognising that cycles exist doesn't really help to solve the problem, the fact that you know they exist doesn't really solve the problem if you are in a bust situation -- you can't just say I'm going to sit on my hands and wait for the boom to come. So what did Irving Fisher and John Maynard Keynes, what were their solutions for economic downturns and depressions?
Justin:
Both of them thought actually that this cycle isn't the natural order of things, and there ought to be some way to fix it, and Fisher focused on the value of money, he was convinced that it was inflation and deflation, you'd have some amount of ups and downs, but what really caused harsh depressions and big booms were prices, prices were rising everywhere, all across the economy, not just in the markets, that caused a certain kind of behaviour, and then when they totally crashed, especially in the US, but to a certain extent all over the world in the 1930s, that brought a slew of other problems, because people have debts that they have to pay back, and if suddenly they're getting paid half as much, they can't pay them back.
So Fisher focused on the money supply, and Keynes, basically Keynes and Fisher were kind of communicating and arguing with each other throughout the Twenties, and were basically on the same wavelength. In the Thirties, Keynes decided that wasn't quite enough, and that government had some role beyond its control over the money supply in sort of pushing and pulling the economy, and that's what we mostly know today is Keynes' economics, this idea that you run a deficit when times are bad, and in theory you run a surplus when times are good, but governments have trouble doing that.
David:
But there was another guy at the time, a guy called Freidrich Hayek, who had a different view altogether, he was the one that said that governments shouldn't really interfere in what's going on in the markets. So why did he come up with this different idea altogether?
Justin:
Part of it is just where Hayek was in the 1920s, and Teens, he was in Austria, which was experimenting with all different varieties of socialism, and not really succeeding economically, whereas Keynes was in London, which was for the most part still in the Teens and Twenties, well except during the war, was sticking to a free market, gold standard line, and that was causing problems.
So I think part of it was just pure reaction to environment, but I also think Keynes and Hayek were kind of talking about different things; Keynes sort of had this idea that government could come in at a tough time and give the economy a shove, I don't think he ever thought governments should be deciding everything, but he thought it could be helpful, whereas Hayek just had this very strong feeling that no government planner would ever know what the right time to intervene was, and that markets and market prices were really the best way to allocate resources and decide where to go next.
David:
So what do you feel then? -- who do you think was right? Was it Hayek or Keynes?
Justin:
That's the problem with me, I come down in the middle a little bit, I think most of the time Hayek is right, I think most of the time you're far better off leaving it to markets. I guess the one area is that Hayek didn't really differentiate between financial market prices and prices for goods, and I think a lot of finance scholars then in the Fifties and Sixties sort of took his arguments and ran with them on financial markets, and said, gee, financial market prices must be right, but when you think about it, financial markets are actually kind of different, if the price of eggs go up, people eventually start buying fewer eggs, or farmers raise more chickens and produce more eggs, whereas in financial markets, at least over the short to medium term, rising prices causes people to buy more, because if people think, oh, I want to ride this tide, and so at least in the short to medium term the kind of supply and demand forces that make prices for goods pretty reasonable and a pretty good indication of their worth don't really apply in financial markets.
David:
OK, so let's introduce a third character into this, we've got John Maynard Keynes, we've got Freidrich Hayek, the Austrian, we've also got another guy called Milton Friedman. Now Friedman would probably agree with Hayek more than he would agree with John Maynard Keynes, wouldn't he?
Justin:
He would, but Friedman was an interesting combination, because he also resurrected the economics of Irving Fisher, and this whole idea that the money supply was really important, and that if you could just keep prices relatively steady, prices in terms of inflation and prices for goods, you wouldn't have really big economic problems, so he believed that there was this role for a federal reserve, or what he really wanted was just this machine that pumped out money at a 2% rate a year, but nobody's ever been able to figure out how to make that, but that was still a government role, he was abdicating to the gold standard or anything else, but then, in everything else, he was all for free markets.
David:
But the thing about Friedman was, he was the person that the US Government turned to when they had the problem of deflation in America, or the fear of deflationary spiral, and they did exactly what Friedman would have done, which was to cut interest rates completely. But what effect did that have on the rest of the markets by doing so?
Justin:
You mean what Bernanke and the Fed have done over the past couple of years?
David:
Well, I was thinking more in terms of earlier than that, when America was having problems in the 1970s and they decided then to actually cut interest rates, but that had another effect …
Justin:
But without … there was no deflationary, I mean, in the Seventies the general feeling is that the US Government didn't listen to Friedman, and was too willing to let inflation get out of hand, because it was concerned about hurting the economy, and not until Paul Volcker came along and took over at the Fed did we get back to a sort of Friedmanite policy, which was all about keeping the dollar stable and keeping inflation in check.
David:
But didn't they also, when they started to cut interest rates, that it had an effect on the housing market, it actually put too much money into the US economy?
Justin:
Right, definitely.
David:
And so why didn't they do something about it? Why did they allow a bubble to form in the housing market without stopping the prices from rising unabated in some ways?
Justin:
It's really hard to tell what the Fed and what Alan Greenspan in particular were thinking in the early 2000s, but I think a lot of it was this sense that, OK, there's a real fear of deflation in 2001 and 2002, we have to deal with that, I talked to Milton Friedman some during that period, and he was a little worried that they were overdoing it, but he wasn't particularly critical, and when housing prices rose, there was just this real tendency to fall back on the idea that, oh, well they must be rising for a reason, especially now because all the loans are securitised, they're in markets, it's not some dumb bankers making the decision, it's the all-wise markets for mortgage securities that are deciding how they should be priced, and Greenspan had learned the lesson that he didn't want to second-guess financial markets, and so he didn't.
David:
But the problem is, a lot of people at the time saw that house prices were rising beyond the affordability of ordinary people, so therefore you have to say that, yes, there was a bubble being formed, but I come back to the question which is, why didn't somebody do something about it, why didn't somebody say, yeah, either build more houses in order to bring the house prices down, or in some ways try and stop house prices from going up? You can't just use the Alan Greenspan line and say, well, you know the markets always know what's best?
Justin:
Obviously there are political considerations, and there were a lot more houses built in certain parts of the country where it's easy to build houses, especially the South West, but I think part of it was just that we have a very powerful real estate lobby in the United States, and they weren't going to be really happy with any policy that said, hey, let's bring house prices down, and I don't think Congress would have been sympathetic to it back before the crash either.
So there were political reasons, there were ideological reasons, and one thing that I'm just thinking of now is, I've talked to a couple of people in the Economics Department at the University of Chicago, which is sort of where the efficient market idea came from, the temple of free markets and free men, and basically they would sit around in the Faculty Club five or six years ago, and all talk about how crazy it was, how high house prices were, but none of them came out with any sort of big theory or plan for how do we do something about it.
David:
Which goes back to what I said earlier on: a lot of people today with hindsight will say, yes, there was a problem, and I'm sure there were people at the time then who said, we think there's a problem, in our guts we feel as though house prices are rising, but why didn't the stock market investors see the possible linkage between what was going on with the housing market and what could possibly affect the stock market at some later stage?
Justin:
I mean part of it is just, and this happened long before there were finance professors, or even before there was a Manchester Statistical Society, it's just when times are good you go with it, and the people who, the Cassandras, all are made to look stupid, and so you start believing the hopeful people.
But I do think another element, and that's why I think my book is of some relevance, I started it long before this financial crisis, so it's not only about this crisis, but it's relevant because the dominant theories of finance and economics that are supposed to explain financial market prices, and why they do what they do, don't allow for bubbles, and there's been lots of recent research that does explore bubbles, but sort of what gets taught in the text books, if you're getting an MB and you take a finance class, there's really no explanation of bubbles.
David:
But there was one guy at the time called Robert Shiller, who is famous for his phrase, "Irrational exhuberance". Now, why didn't anybody pay any attention to what Shiller had to say?
Justin:
That's a really strange one, because I can sort of understand people, and he first, in the late Nineties, was sounding the alarm about the stock market, and the first edition of his book ended up coming out in March 2000, which is exactly when the stock market peaked and began to fall, and you would think that after that record, when he came out two or three years later with a new edition of the book with this big new chapter about housing prices saying, "This is out of control, something has to end", I just don't get it, because I wrote about him, he got a reasonable amount of attention in the media, but somehow or other everyone just decided, oh whatever, it's Shiller again.
David:
So do people in general just sort of adopt the ostrich technique, which is to bury their heads in the sand and say, things will sort themselves out at some later point in time?
Justin:
Right, and also again, at least in the short term, if you're working on Wall Street or in the City, if you're working in these fields, and you're not really investing your own money so much as giving advice or managing other people's money, you're judged on a quarterly or annual basis, and the best way to make money most of the time is to go along with the flow.
David:
I think there might be some people out there who disagree, I mean the contrarians will say, that is exactly the wrong time to actually go into the market and buy what everybody else is buying.
Justin:
I completely agree, but the incentives, if you're a professional money manager, make it hard to do that, if you're investing for yourself, and you have the right mindset and discipline and all, you can take advantage of that and bet against those people, but if you're running a unit trust or something, and you're betting against the market for three years running, and you're wrong, you're out of a job.
David:
You're quite right, I mean the number of times I've heard fund managers say, it is very difficult to swim against the tide, it is much easier to go with the tide, because you don't really want to be left standing when the tide has actually gone away from you.
So can we fast-forward to today, Justin, and have a look at what the governments are doing? I mean, your gut feeling, given that you've written this book, what does your gut feeling tell you about what governments are doing today, and we're talking about governments all over the world? Are they applying the right medicine to solve this economic downturn that we're in?
Justin:
I think in sort of the panic mode moment, yeah, they did it very sloppily, probably wasted huge amounts of money, but I do think we had a fragile enough system, that it could have just unravelled in a really horrible way, and there are people, I don't know if there are as many is the UK, but there's certainly a lot of people in the US, especially Republicans in Congress, who say, ah, we should have just let them all fail.
That just scares me, what might have happened had they done that, so at that level, yes, but everything they've done since, I think, has been quite a muddle, and I don't think there's any real clear philosophy of, OK, what do we want financial markets to look like, what do we want them to do for our economy?
David:
So if Friedrich Hayek was here today, what do you think he would recommend to governments to do?
Justin:
He would be saying, you should have let all the banks fail, and you should just let markets sort it out, and I just don't think he's completely right about that, I think there's a huge amount of wisdom in Hayek's work, but I just don't buy that.
David:
So in actual fact what were are adopting at the moment is almost Keynesian economics, we're actually saying that, yeah, the governments are doing the right thing, and because private investors are not using their own money, the government has to step in, so you're almost leaning towards John Maynard-Keynes then?
Justin:
Oh definitely, I mean the world over the past couple of years has gone very Keynesian, and I think that was the right thing to do. The difficulty is knowing when to snap out of that mode, and start letting markets work again.
David:
But can you actually mix and match Keynesian as well as Hayek-type economics? I mean, can you mix the two together? – just as they've done now, they allowed Lehman Brothers to allowed, and that is almost Hayekian in some ways, isn't it?
Justin:
Right, I guess in the middle of a panic, that can sew a lot of confusion, but I do think over the past 60 years we've been mixing Keynesian and Hayekian and kind of going back and forth, and the pendulum swings, and we overdo it in one direction, and then we start to swing back a bit. I just don't believe that you need to be completely consistent all the time in economic policy, and only follow one approach. Clearly we're swinging back in the Keynesian direction since the late Seventies, with Thatcher, and in the early Eighties Ronald Reagan here, the pendulum was definitely being pushed in Hayek's court.
David:
OK, so here's the $36,000 question Justin: will there be another crash?
Justin:
Yeah, definitely.
David:
I was hoping you were going to say, "no", that we've actually learned our lessons of the past!
Justin:
No, it's interesting, between the 1930s and the 1980s, there really weren't financial crises, at least in the developed world, of the sort that had become regular occurrences before the 1930s, so in some sense you can stop them, I mean the way it was stopped was really heavy regulation of the financial markets, and possibly over-regulation, but it did keep financial crises away. I think what you want is some sort of balance where you have the crises occasionally, but people are, to a certain extent, prepared for them, and you don't have a whole system that's so fragile that the collapse of a Lehman Brothers suddenly threatens a breakdown of the global economy.
David:
So how can the little people like myself, and also our listeners, we are just little dots as far as the whole economic problem is concerned, but what happens to our finances really matters a great deal, so how can investors prepare for the next crash? How can we get ready, apart from just wearing a hard hat?
Justin:
The one thing is, little guys like you and me were not buying triple A-rated collateralised debt obligations, and we weren't buying the stupidest stuff, and for the most part weren't hit the hardest, it seemed in late 2008/early 2009 that we were all in big trouble, but the markets have bounced back a lot, and I think sort of standard investing advice, diversify a lot in equities unless you're at retirement age, actually still works over time.
David:
We still got caught out though, didn't we?
Justin:
We did, but we didn't get caught out as badly as Royal Bank of Scotland or Sabre, or any of that.
David:
Or unless you were working for Lehman Brothers!
Justin:
Right, I mean I think the way most of us have been hurt is much more in terms of our income and our jobs, because in terms of investing, yes, everybody's asset values have gone down a lot, but there was also this wonderful opportunity early last year to buy stocks on the cheap, and I imagine some savvy Motley Fool members took advantage of that.
David:
As long as you have the cash, but the problem is, if you were fully invested, you didn't really have any room to manoeuvre, because you thought like everybody else did, that you look at the stock market, they're telling you the P/E ratio is somewhere round about 15, so you think, well that's not particularly expensive, I'll go and buy some more, I've got my money in a tracker fund somewhere, so therefore the index tracker will just follow the market up, but you didn't expect this catastrophic fall in share prices, and also asset prices, that dragged you down with it, you didn't do anything wrong, you didn't take out an excessive mortgage, and so you got caught up in it also.
I guess the two things really are: first of all, what you're saying is, we will possibly have another crash at some later stage, that is almost inevitable?
Justin:
Right, and I guess the real concern now is whether all the government action, to minimise the impact of this crash, is just leading to another crisis in government debt, and I don't know the answer to that, but it's clearly a risk.
David:
Well I think that's the worry that a lot of people have at the moment, that all of this quantitative easing, printing of money, all of this is going to cause another problem somewhere else, and they don't really know where that somewhere else is, but just like you and me and everybody else, we know there's going to be another one, and people just want to know, how can I take action? How can I take preventative action to stop that from happening to me? And what you're saying is, it's almost impossible to, is that right?
Justin:
Clearly there are geniuses who were smart enough to put all their money in gold a year and a half ago, but I don't think that means putting your money in gold is going to be the genius thing to do right now. One of the lessons from investing is, whatever worked the last time around, whatever was the safe thing last time, probably won't be the safe thing next time, and I mean the other really great safe investment of this crisis has been US treasuries, and I take the lesson from that that, I don't know, I don't think the US is going to default, but I think there's going to be a pretty high inflation risk here in the US, and the dollar may keep declining against currencies around the world.
David:
So I guess what I'm taking away from you at the moment is, the best plan for a lot of people is to have a really diversified portfolio, have all sorts of things in there, so that if any one were to be hit. One of the problems that we had over here, Justin, was that so many people were putting so much store in their homes, because the homes suddenly became 80% of their wealth, and they thought, well what's the point in investing in the stock market? -- I might just as well carry on buying a bigger house, because when I decide to retire, I'll just either downsize my home, or over here they would take some equity out of their house, in other words they would borrow against their home to fund their retirement, so those were the people, I think, who were caught out the worst from this crisis?
Justin:
Yeah, and it's interesting, because the advice I'm giving is basically what a finance professor who believes markets are efficient would give, which is kind of interesting, that I come around to the same conclusion, but I guess what it is is, clearly there are people out there, and there are people listening to this podcast, who have a better idea, and can sort of outsmart the market and avoid the problems, but sort of by definition most of us can't, and so if you're thinking, well what's the best generic advice you can give about dealing with the market? – and it's to be pretty well diversified. In the middle of a panic, that doesn't seem to help, because everything goes down, but if you can ride out that panic, if you didn't borrow money to buy these assets that you have, then they usually go back up again afterwards.
David:
I think that's a safe piece of advice, and I think we'll probably end there, Justin. Now, I end each podcast with a quote, and today's quote comes from a man called George Fisher, none of the characters in your book is called George Fisher, this is somebody completely different, and he said, "When you aim for perfection, you discover it's a moving target", and I think that is what part of the problem that people have, they're trying to quantify something that's going on in the economy, only to find that it's moving all the time, and it's almost impossible to. Would you agree with that?
Justin:
Definitely, and that's a major lesson of this book, is as soon as people had this perfect theory of how the market works, the market learned this theory and changed its behaviour.
David:
That's wonderful, and I think we will end there. This has been Money Talk, I have been David Kuo, and my guest has been Justin Fox, author of The Myth of the Rational Market. If you have a comment about today's show, you can post it on the Money Talk web page, which you can find at www.fool.co.uk/podcast, and if you have a suggestion for future shows, you can email me at moneytalk@fool.co.uk. Until next time, have a great week.
