People want to understand phenomena. We want explanations for what happens. Journalists, especially TV and radio journalists, want explanations that can be summarized in 1-2 sentences in a sound bite. Randomness is pretty scary. And anything that’s too complex to understand easily looks a lot like randomness.
So what triggered this little nugget of metaphysical social observation in an economics blog? Reporting on the stock market! Everyday we (those of us who read, listen or watch the news) are treated to not only reports of what the major stock market averages have done that day, but we’re always given a simple and easy explanation. Just look at today in the NYTimes. I’m not trying to pick on The Times, it was just the first thing showing on Google Finance as I wrote this – any source, any time and you’ll get similar simplistic explanations.
The move announced by central bankers on Wednesday to contain the European debt crisis led to euphoria in global stock markets…
Krugman posted this evening that he didn’t understand it. But he approached it from the standpoint of “does this action by ECB make economic sense that should improve stock prices?’. I think he’s right that it doesn’t make sense, but I think he misses a bigger point. It’s foolish to try to attribute the movements of stock market averages on any given day to the any particular sentiment of investors or any particular logic of rational investors.
The markets are huge. We’re talking hundreds of billions and trillions of dollars in trades. Daily volume is in the billions of trades everyday. It’s complex, folks. The reasons these trades happen and why they happened at the prices they did are really, really complex. It’s kind of like ancient peoples trying to understand the stars and without even a telescope or any calculus! Unfortunately, like them, we want simple explanations. So we invent them. And like ancient peoples we make sure our explanations support and reinforce whatever religious or superstitious beliefs we have. [readers are advised not to try to decide what my spiritual beliefs are based on that sentence - it's complicated].
There is a belief that supports much of this daily “this is what the market did and why” reporting. It’s actually based on the theory that markets are rational and “efficient”. There’s an economic theory that holds that prices in financial markets accurately reflect the current state of all known information and news regarding the future flow of earnings and profits from firms. It’s demonstrably false, but it has quite a following among neoclassical economists. It cannot be proven and evidence exists to contradict the hypothesis (see Quiggin’s Zombie Economics), yet it’s taken as article of faith among many, many economists. So much so that some non-believing economists have begun to refer to neoclassical economics as theo-classical.
The whole idea that there’s a single sentiment or key piece of news that drives the stock market each day is made even more absurd when we realize that most trading isn’t even being done by humans! The significant majority of all trades are done by computers based on algorithms such as “buy this if the price has moved x in the last y seconds”. Even more of the trading is done by casino-oriented short-term trading by large banks and hedge funds who are only trying to figure out what they think the other traders are going to do a few seconds before they do it. (also known as Keynes’ beauty contest).
Markets are the collective, sum judgement of lots of complex decisions. Even if all the individual decisions were rational, there’s still no reason to believe the aggregate outcome can be represented as the decision of some hypothetical rational being. So next time you hear or read some talking head pontificate that “the markets are saying…..”, just remember there’s little difference between that modern commentator and some ancient priest in long gown claiming that “the gods are saying….”