Book Review: Justin Fox, The Myth of the Rational Market
Those interested in the intellectual history of modern finance theory will find Justin Fox’s The Myth of the Rational Market riveting. It is familiar territory to anyone who has written on the subect; Fox, a writer at Time, uses the pop style of financial journalism. Even so, many useful insights appear and the arrangement suggests relationships among ideas worth exploring.
Notably, this book, which Fox began writing in 2002, is not about the current financial crisis. But of the dozen about the current crisis I’ve read so far (several reviewed on this blog) it is far more illuminating in relation to it. Fox demonstrates how the ideas hatched by academic financial economists during the past 45 years, and adopted with alacrity by nearly everyone else, from bankers to law professors to regulators, contributed significantly, though unwittingly, to prevailing woes.
Fox’s story, using lucid and engaging prose, based on well-documented research and interviews, concentrates on how academic finance departments reshaped our world, not always for the better. Beyond the book’s scope is a parallel story, yet to be written, about how law professors, applying the finance work, wrought similar change.
Fox does a wonderful job exploring the content and evolution of modern finance theory and its extraordinary influence. Beginning in the late 1950s and intensifying through the early 1990s, and never much retreating, MFT: (a) brought purportedly sophisticated tools to measure and manage financial risk, in stocks, options and derivatives (primarily Sharpe and Linter, plus Black and Scholes); (b) gave instructions on how prudent investors do not examine individual investments but portfolios (primarily Markowitz); (c) imagined how efficient markets digest all relevant public information so systemic destruction could not arise from problems like accounting manipulation or congregation of financial risk (especially Fama); and (d) how business value is unaffected by a company’s capital structure (mix of debt and equity) or dividend policy (Modigliani and Miller).
Fox explores how these ideas, never firmly proven but extensively studied and widely believed, despite considerable counter-evidence, constituted the primary training ground for forty years of finance and MBA students. Armed with these ideas, they have run corporate America and its financial institutions for the past two generations. Some results may have been desirable, such as the rise of the index fund as a popular form of investing (thanks to Jack Bogle). Others may not have been, such as the proliferation of stock option compensation and the orgy of junk-bond financed corporate takeovers of the 1980s (which Mike Jensen initially championed and later repudiated).
Mostly beyond the scope of Fox’s book, law professors embraced these ideas with alacrity, beginning in the 1970s, intensifying throughout the 1980s and 1990s and even continuing today (enthusiasts date to Manne and Winter, later intensified by Romano and a hundred others). This had considerable implications for substantive law in several areas, including the law of investment trusts, securities regulation, financial instruments regulation, executive compensation and the law of mergers and acquisitions (in both federal securities regulation and state corporation law).
MFT formed the basis for large bodies of corporate and securities law scholarship in the past several decades, especially concerning mergers and compensation. The ideas ultimately became so pervasive as to provide the fundamental baseline for even beginning to think about these subjects and the participants in them (an assertion originally made by Gilson and Kraakman thirty years ago and often repeated).
To be sure, many legal scholars (including me, along with Bratton, Gordon, Hill, Hu, Langevoort, Lowenstein, Prentice, Stout) have exposed fundamental problems with many MFT stories. Anyone can see problems in the tales by looking at numerous contradicting calamities, like: (a) the 1987 stock market crash, (b) the 1998 implosion of the hedge fund Long Term Capital Management (run by MFT pioneers using its tools), (c) the massive financial frauds epitomized by Enron in 2002, and (d) the 2007-xx crisis epitomized by widespread failure of financial products, firms and markets (and of regulator/overseers, like Fed economists and SEC lawyers and accountants).
Fox’s book shows how those who invented MFT models were initially attracted to the academic research as a way to find the truth, noting how much of the research was careful not to overstate what was being discovered. But this narrative also shows how hubris entered into the development and dissemination of the ideas, leading to exaggeration of the truth being discovered. People got caught up in the thrill of participating in the vanguard of a splashy intellectual movement; many, like those at LTCM, sold their reputations and services to investors and investment firms. The story shows a discipline getting carried away with itself.
Fox also carefully examines competing strands of scholarly objection to dominant MFT views. This body of knowledge initially pointed out anomalies (relatively modest departures from what models predicted but which they could not explain) and later showed more dramatic shortcomings, like there is too much trading and too much price volatility for MFT models to hold up. (Exemplary authors of works making these contributions are Shleifer, Shiller, Summers, Thaler).
Put more broadly, market participants can over-react and under-react to information in ways that only behavioral stories rather than traditional MFT stories could explain. That critique of financial markets could be applied to over-excited devotees of MFT too, evoking the old lament about how “What the wise do in the beginning, fools do in the end.”
Enthusiasts of MFT may have gotten carried away and whatever its validity, it may be more important to recognize its limits. It is to that debate, over how much value MFT ultimately offers, that Fox’s objective and thoughtful book contributes. Wherever one stands on that debate, and Fox’s analysis, for lawyers and legal scholars, equally riveting and controversial is a parallel story of MFT’s rise, dominance, and endurance in law schools. But that is a story for a different book.