Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State

by Roman Frydman, Michael D. Goldberg

A powerful challenge to contemporary economics and a new agenda for global financeIn the wake of the global financial crisis that began in 2007, faith in the rationality of markets has lost ground to a new faith in their irrationality. The problem, Roman Frydman and Michael Goldberg argue, is that both the rational and behavioral theories of the market rest on the same fatal assumption--that markets act mechanically and economic change is fully predictable. In Beyond Mechanical Markets , Frydman and Goldberg show how the failure to abandon this assumption hinders our understanding of how markets work, why price swings help allocate capital to worthy companies, and what role government can and can't play.The financial crisis, Frydman and Goldberg argue, was made more likely, if not inevitable, by contemporary economic theory, yet its core tenets remain unchanged today. In response, the authors show how imperfect knowledge economics, an approach they pioneered, provides a better understanding of markets and the financial crisis. Frydman and Goldberg deliver a withering critique of the widely accepted view that the boom in equity prices that ended in 2007 was a bubble fueled by herd psychology. They argue, instead, that price swings are driven by individuals' ever-imperfect interpretations of the significance of economic fundamentals for future prices and risk. Because swings are at the heart of a dynamic economy, reforms should aim only to curb their excesses.Showing why we are being dangerously led astray by thinking of markets as predictably rational or irrational, Beyond Mechanical Markets presents a powerful challenge to conventional economic wisdom that we can't afford to ignore.

Genres: Economics

288 pages, Kindle Edition

First published January 1, 2011

Reviews

[Nick Klagge · Rating 3 out of 5]

Four stars for the concepts, three stars for the book. I first learned about Roman Frydman from watching a video of his presentation at the Berlin conference of INET, a somewhat unorthodox economics association. The research program embodied in this book strikes me as extremely valuable and promising for economics. Basically, almost all modern economic writing on financial markets begins from the assumption that asset prices and/or fundamental factors evolve, even if unpredictably, according to known probability distributions (the "ergodic" assumption). Second, the economist assumes that all agents being modeled must know the model being posited as the "true" model, and thus make their forecasts consistently with it (the "rational expectations hypothesis"). Frydman's argument follows Keynes and other early moderns in seeing "non-routine change" (i.e., that which cannot be modeled by ergodic assumptions) as the fundamental fact of capitalism and of financial markets.

Of course, throwing out the ergodic assumption and the REH is a huge setback for the economist-as-modeler, since it's very unclear how it would be possible to say anything useful about inherently unpredictable change. But I very much appreciate the effort to start moving in that direction--to stop looking for the keys under the streetlamp, as it were. This book is the non-technical version of the material, so I can't completely judge the modeling approach, but it strikes me as both reasonable and useful.

I really appreciated the analogy drawn between ergodic modeling and the Soviet attempt at a planned economy. It is certainly a provocative one, but I think it does highlight useful parallels and makes useful points about the distribution of knowledge.

One thing I didn't like as much was the section on possible policy responses to asset-price swings. It seemed less carefully thought-through than the other sections of the book. Perhaps it is de rigueur for a popular-consumption book to have a "policy angle," and perhaps the policies discussed really would be useful, but there didn't seem to be enough space to develop them as really compelling arguments.

[Lucille Nguyen · Rating 4 out of 5]

My take: acknowledging risk and uncertainty (in a Knightian distinction) as being central to the price system is incredibly important. And there is a lot of good history and theory in the book. but when the authors go into advocating policy interventions and actions, the book grows much weaker. Central planners in both socialist and idealized economic models are unable to perfectly predict the future, but economic policymakers should seek to pop bubbles when said bubbles are bad economically?

The rule of thumb they used was P/E ratio to determine, but this itself seems like a Goodhart's Law issue in practice, a measure turned into an objective ceases to be a good measure by virtue of being an objective. Seems like the book would have been a lot stronger in just the theory and empirical evidence. A good book but the ending (Ch. 9-12) is not as strong as the majority (Ch. 1-8) of the book.

[InvestingByTheBooks.com · Rating 5 out of 5]

Beyond Mechanical Markets is among the best and most rewarding books I have read for a long time. Two renowned professors at NYU and UNH, present an economic theory—Contingent Market Hypothesis—that explains how the financial markets really work. I believe most seasoned investors will agree, and even applaud the reasoning, though a naïve practitioner might say there is nothing new here. In reality it is actually a forceful attack on contemporary economic and finance theory. I have never read a more elegant explanation on why the Efficient Market Theory (EMT) has such empirical failings, nor have I genuinely understood the epistemological flaws with Behavioural Finance (BFT) before. Financial markets are neither predictably “rational” nor irrational. Both fundamental and psychological factors matter, but not in a way that can be pre- specified with mechanical rules.

The book’s main purpose is to bring back the notion of imperfect knowledge and non-routine change in fundamentals into economics and finance. There are many well-grounded statements in the book that contrast current mainstream theory, e.g.: Outcomes of financial markets are not predetermined with a minor random error component (EMT); We are not think-alike robots in a mechanical system (Rational Expectations Hypothesis, REH); Sustained larger swings—bubbles—in asset prices are not due to irrationality (BFT). It is understandable why most academics prefer a deductive approach—with rigor and consistency in focus. But knowledge in social sciences evolves over time and when facts change, we change our minds and therefore our forecasting and forecasting strategies.

The book consists of two parts: The Critique and The Alternative. Both are intriguing readings. The Critique is very educational. Even true believers in efficient markets will get some musings. It’s also fascinating— and scary—to witness how some descriptive theories from doubting professors can develop into a decisive dogma. Anyone reading the original works of John Muth (REH), Paul Samuelson (Martingale Property Model) and Eugene Fama (EMT) will be surprised how this fusing could turn out into strong beliefs that the outcomes of financial markets are predetermined. Why are we not more sceptical to today’s mantra with index funds? Actually, some of the assumptions behind these theories are so absurd it is almost funny.

In the Alternative, the authors reintroduce some of Keynes’ thoughts with a slightly new interpretation which is probably the most interesting part of the book. Keynes’ segmentation of market participants into short–term and value speculators and their dynamic interactions, is one of the foundations in their theory. Non-routine changes in the currently important fundamentals, occasionally reflexive forces, moderate guarded revisions due to uncertainly, the speculators’ different investment horizons and risk perceptions are key variables to explain swings in asset prices and their boundaries although not their magnitude and duration. And risk is not volatility—it is the gap between price and value. The Contingent Market Hypothesis, although not perfected yet, is appealing in many ways. Even some of the “puzzles” are no longer anomalies with their theory.

But the book has some minor flaws too. The final chapter on policy feels a bit sketchy. The target audience is slightly unclear. It is written in a non- specialist language but without good insights in economics and finance it is a difficult read. The sentences sometimes even complicate an already complex subject. Moreover, the basic conclusions are repeated too often in my opinion. Better if the book had been shorter and more concise.

All in all, it’s a great thought-provoking book. A measured economic theory that acknowledges the workings of portfolio managers and financial analysts... “The fact that it is possible, and that some individuals do succeed, provides powerful incentives to look for signs of change and attempt to speculate on them.”

[Sheng Peng · Rating 1 out of 5]

Gave up at about 20%. This bone-dry stuff dehumidifies the house.