Fads, Frenzies, and Finance

Barcelona – The financial crisis, credit crunch, and ensuing economic downturn have severely damaged the credibility of financial markets, institutions, and traders. More and more people are claiming that markets are characterized by irrationality, bubbles, fads, and frenzies, and that economic actors are driven by behavioral biases.

George Soros’s recent book on the credit crisis is a good example of this line of thinking. He even suggests that established financial theory is obsolete. His view, in essence, means that the current financial crisis is the final proof that markets do not process information efficiently. If this is true, we are closer to John Maynard Keynes’s view of the market as a casino than to Friedrich von Hayek’s view of it as a marvelous mechanism for processing dispersed information.

For example, the recent spike in oil prices would have been driven by an irrational frenzy in futures markets. Market operators would have miscalculated systematically, been overconfident about their information, and overreacted to news. I believe, however, that there is another explanation for these phenomena, which is based on rational calculation and information processing by institutions and traders.

The problems we see in the financial markets have very much to do with lack of good information, misaligned incentives, and, in fact, rational responses to the environment. When information is scarce and unevenly distributed, prices may well depart from the reality of fundamentals.