The Soloist & Efficient Markets

The chaos in the L.A. streets was artistically depicted in the recent film about poverty in America: The Soloist.  It is the tale of an L.A. newspaper reporter that takes an interest in a homeless person that is a gifted musician. In the course of the film, the reporter – played by Robert Downey, Jr., takes an honest look at the issue of poverty in America through his friendship with the homeless man, played by Jamie Foxx.  BoyPovertyDirector Joe Wright tackles this issue with sensitivity and grit, while at the same time, avoiding the trap of either idealizing or demonizing those who have found themselves in this situation.  I bring this movie up not with the intent of reviewing the film, but rather as a pointer to a vehicle that viewers can use to become more aware of this pressing problem, not only in America, but around the world.

Rarely will you see an essay that merges the theme of an esoteric economic theory with a socio/political issue like poverty as depicted in a recent movie, but here you will see it.  This is because the two issues are intricately linked.

The July 18th-24th issue of The Economist had two good articles on how the entire discipline of economics is going through a major overhaul as a result of the 2008 financial meltdown.  Macroeconomics in particular has been largely discredited; in large part because the models are too simplistic and their usefulness for guiding public policy has been severely compromised.  The inability of the current models to predict the credit and liquidity conditions after the failure of Lehman Brothers has given pause to many people who were so convinced they were right.  Similarly, in the field of financial economics the much touted Efficient Markets Hypothesis (EMH) is now undergoing great scrutiny. Sophisticated methods of financial engineering emerged from EMH, many of which were implicated in the meltdown. So called institutional frictions led to certain inefficiencies that challenged the very basis of the model. These frictions that emerged in the form of toxic assets in the syndicated mortgage lending market were indeed inefficient.

Not only that, there was more than just the theoretical debris.  There has been a form of human debris that is represented by the increasing number of unemployed people and people living under conditions of poverty.  And, this is occurring not only in the U.S., but worldwide, with some countries hit harder than others.

It is within this context that the new conditions for thoughtful living takes place in the world. Certain economists, like Andrew Lo of the Massachusetts Institute of Technology (MIT) are developing models that reflect both behavioral and rational points of view. A behavioral approach is one that reflects the actions of irrational human beings, those that use herding behaviors, like those we have seen on Wall Street and on Main Street over the past few months. A rational approach is the straw man that has been used throughout the history of economics to characterize a value-seeking individual that acts in their own self-interest to maximize profits.  Andrew Lo’s work is premised on the idea that humans use trial and error as a basic decision-making tool.  It is within this context that institutional friction and societal learning takes place. This new “adaptive markets hypothesis” is one that takes into account the imperfections of the system; in the case of the world economy now, that includes the human debris.

The metaphor of a homeless musician playing Beethoven on the streets is an apt one for our time. He wrote his 9th Symphony at a time of great upheaval in the socioeconomic context of 18th century Europe. I wonder if the musicians of our time will be remembered by those living on the streets in the future. Don’t you think it would be better if we could build a society where everyone had a room to go to, like the Jamie Foxx character ends up doing in the movie?


2 Responses

  1. You say that macroeconomics has been discredited. Actually, it is alive, kicking and very healthy. Econometrics has been discredited – for at least 30 years since its practitioners failed completely to model the stagflation of the 70’s. Von Mises detailed the futility of econometrics, indexing and silly attempts to measure gross economic activity over 50 years ago. I doubt that the ever failing econometricians have gotten the message because they continue their grossly inaccurate modeling.
    Theories of political economy advocating Marxism, socialism, national socialism (Nazism), and fascism have been discredited as have Keynesianism, neo Keynesianism, and all other forms of economic interventionalism. Of course, they too were all thoroughly discredited at least 20 years ago with the fall of the Berlin wall.
    Von Mises predicted the collapse of soviet socialism in Human Action published in 1949. He explained that while terror could ameliorate the deficiency of the profit motive, nothing could overcome the inability to make even the simplest business or economic calculation without market prices. He explained that the soviets survived by leeching off the market prices of the west. However, since prices must differ by locality distortions would accumulate and eventually cause the system to collapse – which it did. Such is the power of the principles of the Austrian school of economics.
    The Austrian school of economics has been resoundingly validated. For over 100 years its practitioners like Ludwig von Mises have been correct on every important economic issue. The principles of the Austrian school explain why the current economic malaise happened. The demographic analysis in Harry Dent’s book The Great Boom Ahead, published in 1993, explain why the malaise happened now.
    The Austrian school did away with the straw “rational” man over 100 years ago. A key principle of that school is value, like beauty, is in the eye of the beholder and those values are revealed by the choices people make in the marketplace. That school of economics only posits that people act purposefully; that is they act to achieve their values.
    You will find only a handful of economists that predicted (in writing) the current catastrophe (including this writer). Nearly every one subscribes to the true free market principles of the Austrian school of macroeconomics. The reason more economists do not follow this approach is that they (e.g. Bernanke, Paulson, Greenspan, Geithner, Sommers, et. al.) would be out of a job.

  2. Seasoned, successful financial professionals have always known the efficient market hypothesis (EMH) was utter nonsense. Of course, Wall Streeters, like most people, will embrace any crackpot idea if they can turn a buck on it.

    Developed by financially barely literate academics and turbocharged by the book A Random Walk On Wall Street, the EMH morphed into complex mathematical modeling of the financial markets that culminated with the collapse of Long Term Capital Management and the financial fallout that caused severe disruption in the markets in the late 90’s. It then mutated into modeling for all sorts of financial instruments contributing to the actual collapse of the world financial system in 2008. Parenthetically, none of that nonsense could have happened in a true market economy as opposed to the byzantine monster we now suffer with.

    Investors can avoid the consequences of such silliness with proper education. Unfortunately, the financial community has been utterly incompetent at that task. In fact, I contend the finance industry is the only one that is a net negative for its clients. More detail on this matter is a subject for another time.

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