how did economists get it so wrong

I. How economists got it so wrong? May the markets be ever in your favour!

After spending a whole summer researching rational markets, company valuations and financial bubbles, we couldn’t ignore a recent hot topic on ‘Should markets be moral?’ as it appeared in the LSE brochure for public lectures.To be honest, after spending a whole year completing a master’s degree and reading more academic journals on the free-rider problem, capitalism and socially constructed virtues that one may imagine, any opportunity to go back to the mode of constant eureka moments at LSE was highly anticipated.

Pardon our ignorance, but we came across the work of Lord Skidelsky/Felix Martin for the first time, but hardly saw their ideas as groundbreaking: bankers are bad, the elite doesn’t contribute to GDP, capital markets do not create wealth, public debt is always written off, markets believe what they want to believe. And moral? I guess we all have our pet topics.

Speaking of which, we wanted to introduce a little series of articles on (ir)rational markets, a result of our modest research on the topic of hot IPO markets and social media companies. Because no company without a sustainable business model can be valued at $100 billion.

May the markets be ever in your favour!

Part I:
How economists got it so wrong?

Ever since the release of The Wealth of Nations in 1776, neoclassical economists have consistently projected the concept that the market system should be trusted.Yet, whenever market failures cast a doubt on this unconditional belief in the system, externalities are inevitably held accountable. Even with view of the 1930s Great Depression, market failures were seen as a necessity bound to happen and certainly not as a fault of the system. However, an alternative view was developed, challenging the notion that laissez-faire economies could function without a facilitator, as for instance argued by Keynes.

If Keynes described 1930s financial markets as ‘those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs…’, then by the 1970s Panglossian finance had overruled that notion. At a time when there was no discussion of investors’ irrationality, speculative trading or financial bubbles, the outcome of the Friedman versus Keynes debate was straightforward – Keynes’ vision that financial markets acted as a ‘casino’ was soon substituted by Fama’s well-known efficient market hypothesis.

Fama’s promulgation that the stock price contains all publicly available information and reflects the company’s true value was further strengthened by the view that financial markets inevitably get all prices right, hence a firm’s ultimate goal should be maximising the value for its shareholders. By the 1980s, the rise of the C-Corporation reiterated the belief that the ‘capital development of the economy’ should be attributed to what Keynes once called a ‘casino’.

Despite the limited evidence supporting Fama’s hypothesis, economists often have looked more into ‘whether asset prices made sense given other asset prices’ rather than examining some of the more obvious questions, for example the relationship between fundamentals such as a company’s earnings and asset prices. This practice inevitably leads to the question of ‘Is there a financial bubble?’

To be continued… (See part II)

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