[This book review appeared in the Summer 2010 issue of The Journal of Social, Political and Economic Studies,

pp. 283-287.] Book Review The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street Justin Fox Harper Business, 2009 Justin Fox, business and economics columnist for Time magazine, has made a singular contribution to the fast-growing literature on the recent financial crisis. The value of many of the other books is that they describe the crisis and its causes in detail. The more recent books are beginning to examine the response that central banks and governments have made to the crisis, and the needed reforms are getting much attention. Fox has added another dimension, although one that will be of interest primarily to readers who probe deeper than most. This has been to recount in detailed chronological and biographical form the intellectual history that spun the web of ideas that so greatly set the table for the debacle. He describes the careers and thinking of many of the leading economic and financial thinkers of the past century. That thinking led to a combination of two very different but, as it turned out, mutually reinforcing intellectual forces. Fox doesnt describe them in quite these terms, but we can see in them (1) a reductionist commitment to a view that an unhampered market economy and financial system function so well that most traditional regulation was an unnecessary impediment, and (2) an equally reductionist positivism that in effect made a fetish of the faux precision that brilliance, mathematics and computer modeling make possible. The first of these an overstated faith in the free market that has dropped the context of law, morality, professional culture, and supportive institutions that classical liberalism, as best conceived, calls for came to be stated in terms of rational market theory. Fox calls this theory a myth, as reflected in the title to his book. Although he is critical of it, his book is largely an informative exposition of what it is and how it developed in finance literature. He says that the best-known element of rational market theory is the efficient market hypothesis, formulated at the University of Chicago in the 1960s. Although the efficient market hypothesis is given a name that suggests it is something more than a mere restatement of rational market theory, Fox tells us that the two are more or less the same thing. Fox doesnt much discuss the broader intellectual history of the past two centuries, preferring to confine himself mostly to the labyrinthine context of modern financial theory, but we can see (and Fox is aware) that the Chicago School of Economics was picking up on one of Friedrich Hayeks central insights. Hayek saw that no one person can know more than a part of the vast array of information that has a bearing on a complex economy, but that prices within that economy, by resulting from the decisions of all of the economic actors, necessarily embody the information that those actors have brought to bear. Thus,

the efficient market theory came to hold that financial markets possessed a wisdom that individuals, companies, and governments did not. It is a leap, of course, to go from this insight to a glorification of the market. It is a leap that was aided considerably by the teaching of Ludwig von Mises, whom the younger Hayek joined as a leading member of the Austrian School of Economics that had started two or three generations earlier in Europe, that a market economy makes an optimum allocation of resources [by which Mises meant the best allocation rather than a merely technical meaning of optimum]. Fox tells us that Chicagoans attacked almost every economic problem with the starting assumption that, absent interference from the government, the market got things right. This led to various off-shoots: opposition to anti-trust laws, hostility toward consumer-protection legislation, and the great deregulation of the 1970s through the 1990s. We can recognize in it also the ideology of the public choice movement, which has bathed government in cynicism (at least partly deserved) by postulating that those in government pursue mainly their own personal self-interest. The Chicago School also gave rise to the law and economics sub-discipline; and this, too, gave intellectual backing to the great deregulation. By the late 1970s, with astonishing rapidity, rational expectations became orthodoxy and the Chicago Economics Department its temple. One of the followers of the efficient market hypothesis was Alan Greenspan, for many years the chairman of the U.S. Federal Reserve system, who held, according to Fox, that financial markets knew best. They moved capital from those who had it to those who needed it. They spread risk. They gathered and dispersed information. It can be no surprise that, in the presence of so wondrous a mechanism, little attention was thought needed to the systemic health of the system: the amount of risk being taken on, whether manias were leading people to quixotic choices, whether incentives were perverse, whether the much-depended-on computer modeling lived up to expectation, whether the accounting profession was able to deal with the complexities of off-balance-sheet banking and of Byzantine derivatives that ran into the hundreds of trillions of dollars, whether credit rating agencies were fulfilling their roles of trust, and the many other facets that were requisite to a healthy system. A great many brilliant minds contributed to the elaboration of rational market theory, while some stood out against it. Foxs narrative follows the chronological development of the various nuances, and tells the story of the individual contributors graduate education and professional role. A sampling of the names he discusses would include Irving Fisher, Wesley Mitchell, Alfred Cowles III, Harry Markowitz, Paul Samuelson, Milton Friedman, Franco Modigliani, Merton Miller, Michael Jensen, Kenneth Arrow, Eugene Fama, Andrei Shleifer but listing them risks omitting others of considerable importance. Foxs elaboration of this intellectual history is, as we mentioned earlier, the singular contribution made by this book. All sorts of innovations flowed from rational market theory into the practical conduct of modern finance: modern portfolio theory risk-adjusted performance measures the corporate creed of shareholder value the rise of derivatives, and, arguably most important, the hands-off approach to financial regulation. Fox cites one of the thinkers as arguing for the freedom to create infinite varieties of new financial instruments because equilibrium theory said it would bring the economic world closer to perfection. A result was that from 1987 to 2007, the face value of over-the-counter derivatives rose from $866 billion to $454 trillion. (Emphasis added)

We started this review by referring not just to reductionist free market ideology, but also to reductionist positivism. (By reductionist, we mean theories that oversimplify by leaving out much that should be considered.) Fox doesnt explore the broader background, but we can recall that a desire to apply scientific method to social issues was a major focus within German universities, and particularly within the German Historical School, in the second half of the nineteenth century. As American graduate students returned from those German universities, what had been known as the philosophy of political economy was broken up into the various discrete social sciences that have formed the basis for separate disciplines for what is now more than a century.1 Mathematics and statistics were central, and have remained so, with the effect that a great deal of work is done that ignores qualitative factors. (To point this out is not to criticize science as such, which is not preordained to commit such reductionism.) Fox picks this up mainly at the middle of the twentieth century. What he says occurred at that time was a scientific [movement], an imposing of the mid-century fervor for rational, mathematical, statistical decision making upon financial markets. The reductionism appears when he speaks of the now-universal convention in economics and finance that until something is said mathematically, it has not been said at all. One of the forms that this has taken has been an infatuation with the allure of faux precision. [A]lternative approaches were sidelined because they never offered anything like the precision and clarity of equilibrium economics. We see an example in financial theory when Fox tells us that traditional ratios of loan-to-value and monthly payments to income gave way to credit scoring and purportedly precise gradations of default risk that turned out to be worse than useless. The dropping of relevant factors carried over, fatefully, to model-building, which was in vogue before computers but was magnified when the seeming magic of computer models came into widespread use. Fox says that by the late 1930s economists became more and more comfortable with ignoring widely recognized realities of human behavior in order to build better models of it. In finance, mathematical risk-management models came to play a central role. Fox says, however, that these models suffered from inherent instability and that they could never fully capture all things that can go wrong (or right). An additional observation will be in order before we conclude this review. There is a lesson in all of this that has particular relevance to higher education. This reviewers oldest grandson, a high school junior, is currently checking out different ivy-league-quality universities to which to apply. In that context, there is considerable mention of the requisite brilliance of the students. We see a similar stress on brilliance in Foxs discussion of the many graduate students and finance professors who spawned rational Although not the result of quite the same influences, a profound deficiency arose in classical liberal thought in the nineteenth century as the emphasis came to rest almost exclusively on economic theory (classical and neo-classical economics), seen as a science rather than a larger philosophy. Accordingly, an atrophying occurred in the thinking that was needed to elaborate on the many other aspects of the free society envisioned by classical liberalism. This is why it is difficult to identify a major classical liberal intellectual movement after the early nineteenth century, even though it is easy to speak as though there was one. It is also why the Left in the United States found it so easy to preempt the word liberal in the early twentieth century. It was filling a vacuum rather than pushing aside an existing and vital movement.
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market theory. We are left with an incongruity: How is it that, given all this genius, there is so little wisdom? The brilliance has taken the world to hitherto unthought-of heights of technical achievement. That is no small thing. But character, integrity, a desire to serve and wisdom have largely been missing. As the world speaks of reforms, a renewed charge to higher education (and to all other social institutions) must be to re-inculcate those missing ingredients. Dwight D. Murphey