Fides quaerens intellectum is a theological method of inquiry in which faith seeks intellectual underpinning for itself. Much of modern economics is also taught and practiced this way.
Just as Catholic priests must publicly profess their belief in the virgin birth, whatever their private thoughts on it may be, so must economics professors avow their conviction that the world is populated by a gazillion emotionless, rational human beings who make decisions in a predictably mechanistic fashion. So, for example, we still faithfully teach our students the same model of physician behavior after 50 years, even though it has never explained more than 5 percent of the variation in the annual hours that doctors actually work. Our analysts have left much room for sociologists and psychologists to do further explaining.
Another economic doctrine that challenges empirical experience is the idea that modern capital markets allocate scarce real resources “efficiently,” that is, so as to maximize the benefit of these resources to society. An integral component of that theory is the so-called Efficient Market Hypothesis which implies that, at any point in time, a myriad of savvy, well-informed traders in the allegedly efficient financial markets have valued the assets they trade in these markets at their intrinsic values, given the then-available information on these assets.
Over the long run this is, of course, bound to be so. At the onset of the asset bubble during the late ’90s, for example, Centennial Technology Inc., was the darling of Wall Street. Its stock rose 630 percent in 1996 alone. Eventually, a junior analyst from a small Midwestern asset management firm — not one of New York’s cadre of hotshot financial analysts — stumbled upon the archaic idea of visiting the firm’s production facilities, only to discover that these were basically non-existent. Soon thereafter, the price of the stock collapsed toward what may have been its intrinsic value. At about the same time, Solomon Bros. had taken Normandy American Inc., public in an initial public offering, only to withdraw the offering one day later after it was discovered that there was basically no company behind that stock either.
Finally, after driving up the NASDAQ Index from 1,000 to 5,000 between 1995 and 2000, the efficient market then took three years to discover that the proper value for the index might be only 1,200, but who really knew? And so it goes. As Arne Alsin, a portfolio manager for Alsin Capital Management Inc. (which makes him a practitioner, not a financial theorist) wrote in The Financial Times earlier this month, when you consider the enormous spread between the 52-week high and low of stock prices for basically stable business firms, “you almost have to laugh out loud.”
Consider in this context the current worldwide calamity triggered by the sub-prime mortgage crisis. Presumably savvy bankers, paid umpteen millions of dollars each year for their presumed contributions to society, invested billions of their shareholders’ money in derivatives whose nature and value these bankers did not seem to understand. Broadly speaking, a derivative is a financial contract whose value is based on the expected future cash flow from some other “underlying” financial contract. In this case the underlying assets were mortgages extended to households with dubious abilities to make payments. Mortgage brokers on commission sucked these borrowers into shaky deals with very low initial monthly mortgage payments, which were then to be reset a few years later to often double their original amount. Typically, these mortgage loans covered over 90 percent of hugely inflated house values in housing markets known to be overheated.
It should not take a financial genius to realize that the values of derivatives whose future cash flow is dependent on such shaky deals are likely to be shaky as well. An intriguing question, then, is how so many presumably savvy, highly paid bankers could get stuck with such derivatives. How did these people end up having to write over $100 billion in asset values off their balance sheets, tanking their banks’ stock prices in the process?
An answer may be the market’s penchant for trading and investing not on “intrinsic values,” but on the “Greater Fools theory.” According to that theory, even savvy investors who should know better will invest in what they know to be overvalued assets, in the hope that further down the pike there will be an even greater fool upon whom these overvalued assets can be unloaded at even more inflated prices.
Fair enough. Trading on the Greater Fools theory can make bundles of cash for bankers, if not for their shareholders. But how that increasingly widespread behavior is supposed to help channel real resources to real uses that yield society the greatest benefit remains an intriguing question. Privately, I shall believe in the virgin birth long before I believe that our financial markets actually accomplish this lofty goal.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Wilson School. He can be reached at reinhard@princeton.edu.
Want to become a ‘Prince’ columnist? E-mail opinion@dailyprincetonian.com by Feb. 15 for an application.
Read More
Why can’t lecturers win the President’s Award for Distinguished Teaching?
Jerry ZhuLet’s acknowledge those who make “boutique teaching” possible, those who work tirelessly to make our rigorous curricula more accessible, and those who dedicate their time to advising and guiding us through all the challenges we face at this University. Lecturers should be eligible for the President’s Award for Distinguished Teaching.
Let’s acknowledge those who make “boutique teaching” possible, those who work tirelessly to make our rigorous curricula more accessible, and those who dedicate their time to advising and guiding us through all the challenges we face at this University. Lecturers should be eligible for the President’s Award for Distinguished Teaching.
Princeton’s administration of justice is Trumpian
Frances BroganThe disparity between the University’s approach to Giberson and its approach to pro-Palestinian protestors reflects a concerning trend of appeasing an increasingly emboldened right rather than resisting the threat it poses to academic freedom and the wellbeing of Princeton students.
Secular Opening Exercises? Don’t throw out the baby with the bath water
Frank StrasburgerThe secular makes no room for the spiritual. What Opening Exercises are meant to convey is the spirit of the institution so that it may be kept alive from generation to generation.
The secular makes no room for the spiritual. What Opening Exercises are meant to convey is the spirit of the institution so that it may be kept alive from generation to generation.
