In a post yesterday, my west coast pal Paul discusses how the Chicago School of Economics Circling the Theoretical Drain:

“In the current issue of the New Yorker there is an alternatively depressing and fascinating piece (Letter from Chicago) by John Cassidy about how the Chicago School of economics – monetarism, rational expectations, efficient market theory, etc. – is circling the theoretical drain. While some economists are abandoning the faith, many are not, and the result is, as Cassidy says, much like what happened in cosmology with Edwin Hubble discovered the expanding universe: Economists have lost their footing and are engaged in everything from rear-guard actions to active peer denunciations, and pretty much everything in between.”

It reminded me of an amusing but true tale of Economics from College. When I started my undergraduate work, I was a double major in Applied Mathematics & Physics. Both disciplines are based upon building blocks of logic, reason, and discipline. All subsequent course work is to a large degree premised upon what came before.

The math/science majors meant that I was obligated to take humanities and other (non-science) course work. So I signed up for (amongst other courses) Economics 101.

It took all of ten minutes into the first class for me to recoil in horror. I asked the prof: “What do you meant that humans are rational? That is obviously not true. How important is this idea to economics?”

The response was, in hindsight, not a surprise: “It is the fundamental building block for all of economics. If you fight that underlying concept, if you do not provisionally accept that premise, you will not be able to understand what comes later.”

So I made what turned out to be one of my very best academic decisions: I gathered my books and walked out the door, and dropped the class.

I am curious if anyone else had similar experiences, either in grad school or under-gradauate work.

~~~

Why is the Chicago School of Economics such an intellectually bankrupt line of thinking? It represents two major cognitive errors: First, it attempts to be an all-encompassing ideology, one that tries to explain much of economics via its fundamental constructs.

As history has shown us all too many times, most such ideologies eventually collapse under their own weight. Rather than recognize their own shortcomings and failures, these ideologies rationalize away stubborn facts. EMH does not permit consistent out-performance by managers, so it therefore comes up with half-assed reasons why Jim Simons, George Soros, John Paulson, Steve Cohen have not trounced the averages over their career. “Must be dumb luck” they dumbly rationalize.

Second, it was based on a rather silly and thoroughly disproven notion: That Humans are rational. Everything that follows is therefore premised upon a terribly faulty foundation. How on earth could that edifice come tumbling down?

If you are presently an undergraduate, and you are being taught by someone who believes in the Chicago School, run don’t walk to the registrar and switch to a different econ professor. It is the intellectual equivalent of a tenured Astronomy professor still teaching the Earth is flat following Ptolemy.

I have yet to determine which is worse: A bad ideology, or any ideology at all. . .

>

Previously:
RIP Chicago School of Economics: 1976-2008 (December 23rd, 2008)

http://www.ritholtz.com/blog/2008/12/chicago-repudiation/

How Economists Got It Wrong (September 6th, 2009)

http://www.ritholtz.com/blog/2009/09/how-economists-got-it-wrong/

Read It Here First: “What Good Are Economists?” (April 25th, 2009)

http://www.ritholtz.com/blog/2009/04/read-it-here-first-what-good-are-economists/

Category: Psychology, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

96 Responses to “Letter from Chicago: F”

  1. ellidc says:

    I love the “How important is this idea to economics?” ingenuousness. It reminds me vaguely of several things.

  2. MorticiaA says:

    A mathematician, an accountant and an economist apply for the same job.

    The interviewer calls in the mathematician and asks “What do two plus two equal?” The mathematician replies “Four.” The interviewer asks “Four, exactly?” The mathematician looks at the interviewer incredulously and says “Yes, four, exactly.”

    Then the interviewer calls in the accountant and asks the same question “What do two plus two equal?” The accountant says “On average, four – give or take ten percent, but on average, four.”

    Then the interviewer calls in the economist and poses the same question “What do two plus two equal?” The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says, “What do you want it to equal”?

  3. MRegan says:

    Any ideology. They bind worse than tight undies.

  4. sysin3 says:

    Supply and demand. That’s all there is.

  5. jritzema says:

    I always looked at the foundation of economics as that people are self serving, not necessarily rational. People make choices to try to maximize benefits or avoid unpleasantness, not that they always succeed.

  6. Richard R says:

    It makes one wonder why those who worship the free market as an infallible, omniscient spirit are never pilloried for establishing a false god. If fact so many religious believers are equally devoted to the god of the market.

  7. Theodore D. says:

    Faced the same thing in B school, but in an investment course, where the Prof.’s defense to my questions about it were: “The people who proved this the won Nobel – what did you win?” It was a little frustrating to say the least, most snickered at me for even bothering to question such a “learned” professor. I learned how constrained institutional investors are and how they don’t get paid to not be fully invested. Kinda scared me that my group was in a consensus that equities were to volatile at the time and we wanted to short (which we couldn’t) or have a large position cash (which we couldn’t), so basically we were mimicking institutional investors. Losing money as we tried to justify what we were doing by looking at 20 year avg.’s and buying bluechips. Great learning experience.

    As to the theory – I kinda see it as a soft science where that insight can help sometimes, but strict equations based on it aren’t always accurate. Kinda like applying a math formula to Freud. Sure he added a lot to the mental health field but I’m pretty sure we don’t all want sex from family members.

    As to alternatives – what would one be? Instead of rock solid assumptions, what would be a better way to go about looking at it?

    Markets strive for efficiency
    Markets are efficient, except when they are not
    Markets are the sum of decisions by irrational agents, the sum of irrational agents does not equal efficiency
    PPT controls everything, except when my picks do well
    Austrian Economics

    I love math so I’ll use the best available theory from which I can apply formulas that don’t really prove all that much, but in using them I’m smarter than you so give me your money to invest. Also called LTCM theory.

  8. dead hobo says:

    BR lamented:

    It took all of ten minutes into the first class for me to recoil in horror. I asked the prof: “What do you meant that humans are rational? That is obviously not true. How important is this idea to economics?”

    reply:
    —————–
    Grow a brain!

    Of course people are rational. If someone offered you, or most people, $1B to hold your hand over an open flame while your family was being defiled in your sight, nobody world accept it. I know, some relatives deserve the defilement (repeatedly), but the hand is too much.

    Thieves and fraudsters control the world to the point that what they do is not theft. Oil doesn’t cost $80+ due to any intrinsic value. It costs this because the system allows massive speculative over investment in the paper that controls the price of oil. Ditto with other commodities in current fashion. HFT loopholes allow a quick draw technique to become the fraud of the day with respect to stocks and whatever else can be churned effectively. Idiotic Fed chairmen institutionalize it.

    Crooks run the world and they are rational. Politicians allow it because most are weak, greedy, and stupid. A myriad of fringe elements make a living from their work. BR, your business expansion would be in trouble if the Fed wasn’t being ‘creative’ and the fraudsters weren’t pumping at will. The textbooks are right. Your explanation is wrong. (I know, they’re not really fraudsters if it’s not illegal.)

  9. LeeX says:

    My MBA finance prof dismissed the notion of bubbles (i.e. markets are perfect), and claimed that he had never heard of the term “hedge fund” (and never heard of LTCM). I could not imagine any other academic field that would tolerate such ignorance. He stated forcefully that greed is good. I guess that he meant that greed is an absolute good, with no ambiguity or downside. One can not have any rational discussion with such a person.

  10. Dead hobo:

    Given what we know about the correlation between smoking and cancer, why do so many people still smoke? Why do they still start?

    We know that seat belts turn minor crashes into mere inconveniences, and major crashes into survivable events. Why do 25% of US drivers not wear their seatbelts?

    History has shown us when stocks become are very expensive, when they are several standard deviations above the norm, at top is near. Yet most investors buy a lot of equities at or near the top.

    The inverse is also true at bottoms — they puke holdings out at lows.

    Why are these things true? Because the monkeys are rational?

  11. Grad Stud says:

    Beware the tenured professor in the discredited discipline

  12. call me ahab says:

    “The inverse is also true at bottoms — they puke holdings out at lows”

    no-one knows the low until it is the low-

    everyone is always trying to catch the falling knife

    same with the high- no-one can know how irrational the values can become-

    Nasdaq anyone?

  13. Well, to stick with our theme, is catching the falling knife rationale?

  14. dead hobo says:

    Barry Ritholtz Says:
    January 5th, 2010 at 4:40 pm

    Given what we know about the correlation between smoking and cancer, why do so many people still smoke? Why do they still start?

    reply:
    ———–
    Given their current situation, smoking has more value than education. It’s a matter of perception. A brain damaged teenoid might think smoking, carrying a gun, and gang banging is OK for them. Most people would look at that as aberrant behavior. To the teenoid, it is growing up and rational in their situation.

    The economic fraudster uses the same logic and excuse as the teenoid gang banger. Only the economic fraudsters have access to those who allow them to go about their business lawfully.

  15. Dawson says:

    My experience at the graduate school level was that economists desperately use mathematics to inject much needed legitimacy into their work.

    That said, I had some great profs who were not afraid to challenge the conventional orthodoxy — unfortunately, they were few and far between.

  16. curbyourrisk says:

    “If you are presently an undergraduate, and you are being taught by someone who believes in the Chicago School, walk don’t run to the registrar and switch to a different econ professor. ”

    I think you mean……RUN don’t WALK….

    ~~~

    BR: Damned Dyslexia. I’ll Fix

  17. cognos says:

    Ah… I dont have as much a problem with “rational” as BR. Its a simple framework to begin with. Einstein was taught classical physics. Elton John probably had piano lessons. You dont need to walk out of class.

    I do find it funny that progressive Nobel prizes are won by overly simplistic, useless! models (Fama-French, Modigliani-Miller) and newer ones that gradually loosen these assumptions or explore a simple dimension of heterogeneity– agents, expectations, information, etc… slowly of course.

    Soros is 100-yrs ahead of the Econ Professor and he has his $20B to prove it. Dual-reflexivity is a model deserving of a Nobel Prize in economics. It basically underpins SAC-style trading as well. Its wierd that they will never understand that…

  18. call me ahab says:

    BR-

    if someone cuts off a chicken’s head and has it run about to determine his decision- then no-

    however- if a person looks at available information and makes a decsion on why this is likely the low or likely the high- then yes

    doesn’t mean they are right

    can markets be irrational? yes- that’s why we have booms and busts

  19. Mannwich says:

    No wonder why we are in the mass delusional state we’re in as the human species. Starting from the totally and utterly wrong premise that “humans are rational”………well, there you go. And here we are.

  20. Steve Barry says:

    Almost by definition, I think, most humans have to be rational, otherwise, there would be a different definition of rational. Certainly ALL humans are not rational.

  21. dead hobo says:

    Mannwich Says:
    January 5th, 2010 at 5:17 pm

    Starting from the totally and utterly wrong premise that “humans are rational”………well, there you go. And here we are.

    reply:
    —————
    Humans are rational. Those who have the power to exploit carry through and exploit.

    You assume rational equals perfect understanding. t doesn’t. All rational thinking is local. The big picture doesn’t register.

    Crooks exploit this and follow the path of least resistance. How do you think private profit and public risk became the norm. Rational exploiting of opportunities.

  22. Upandaway says:

    “I have yet to determine which is worse: A bad ideology, or any ideology at all. . .”

    Ideology is inevitable, it is how we understand the world. The anthropologist Clifford Geertz (one of the few people I truly admire) wrote a whole chapter about it in one of his books. In the end, he defined it as the mental map with which we understand the world… Our tendency is not to look at the world and then change our maps accordingly, we look at our map (which was given to us one way or another) and only *then* do we try to fit the world inside it.

    Such is our rationality: Everything makes perfect sense from the inside, and is therefore rational. But from the “outside”, in another rationality, the same behaviour seem like madness. You just have to “zoom” far enough. To be human *and* aware of this is to be confused. A lot. The others are also confused, but try very hard not to notice.

    And as well they should. Another blogger remarked recently (on the topic of the continuing bear market rally) “would you rather be rich and successful… or be right?”. Just being right doesn’t bring home the bacon. To be fair, neither does being a fool. But some fools are real useful (like Kudlow!) and thus get money, wine and women while being the very opposite of socially useful. Seen from where I’m sitting of course. From where he’s at it all makes perfect sense.

    (Geertz is one of my favourite authors and He sort of invented the anthropological field of Symbolism, a quite powerful theory that few seem to intuitively get the full implications of. Can recommend his work to anyone, thoughtprovoking and written extremely well. All the ideas above are not his, but some are. I dare say none are mine originally.)

  23. Mannwich says:

    @dead hobo: Ah yes, THOSE people (or crooks, if you will) may be perfectly rational but I would argue that those folks are in the minority. The majority (or Sheeple, if you will) are certainly NOT rational most of the time and are subject to the manipulations of those crooks who take advantage of stated irrationality.

  24. Yossarian says:

    What is your alternative to rational markets, rational regulators? Rational politicians? Rational autocrats?

    Humans approximate rationality. There will always be manias/bubbles- it is human nature. Doesn’t matter if we are talking about real estate, art, gold, dot coms, tulips, Pokemon, or baseball cards. As flawed as humans are collectively, asking an individual with even less incentives to be a less-flawed regulator seems more dangerous. The best (only) way to regulate is to constantly evaluate the incentive structures in place at all levels of an economy. For instance, rating agencies, banks, and public pension fund managers were not incentivized towards caution and prudence the way they would have been if they had more skin in the game.

    Barry, I read your blog every day and you put out some very interesting stuff. But my beef with you lies in your claim of impartiality when, in reality, you bend over backwards to beat down the Chicago perspective while ignoring the other side when you should be flogging both sides equally. Do you wish to revise any of this post regarding the relative innocence of FNM/FRE in this fiasco?: http://www.ritholtz.com/blog/2009/01/karl-roves-r

  25. Yossarian –

    ~~~

    Being objective doesn’t mean not having opinions –it means having data driven, rational opinions. I beat down Chicago School — which has been dominant for too long — because I think it is foolish, misleading, money-losing bullshit.

    Further, being objective does not mean treating two sides evenly — when one side is the bigger fuck up, you call them on it. Some partisans called it partisan to spread the blame about 60/40 GOP/Dem — but that was how the chips fell.

    Declaring everything 50/50 — when its not — is not even handed, its foo0lishness

  26. whskyjack says:

    I am perfectly rational
    It is the rest of you who are Bat sh*t crazy
    If all of you could just be more like me……………..

    Jack

  27. Mannwich says:

    Or maybe I’m just confusing stupidity with being irrational. Or maybe the two aren’t mutually exclusive? ;-)

  28. dead hobo says:

    Mannwich Says:
    January 5th, 2010 at 5:29 pm

    @dead hobo: Ah yes, THOSE people (or crooks, if you will) may be perfectly rational but I would argue that those folks are in the minority.

    reply:
    ————
    Numerically, they are in the minority, but their monirity power controls the majority. Who has more power over the financial markets – 1 GS or 100 MM sheeple functioning as a gaggle, each and all applying rational self interest? No part of the gaggle will stand up because they will be ignored if they stand and rise. Or worse if they might be effective.

    Uncle Stupid should be representing the gaggle, but he is corrupt. GS and others with similar influence wins. Hangers on profit by the crumbs and by offering supplemental support.

  29. jeffshattuck says:

    I took one econ class in undergrad (never did do overgrad), and lost interest when I discovered all economic theory was based on models that assumed some statements to be perfectly true (all humans are rationale, etc.)

    Ideology is only better than nothing at all if you are willing to change your ideology as a result of reality. Personally, I would prefer an economic approach based on principles rather than a sweeping ideology.

    One more thought: all economic models are like the Pptolemaic universe. They never quite match reality and must be constantly adjusted until the evidence against is just OVERWHELMING.

    Jeff
    http://www.cerebellumblues.com

  30. Mannwich says:

    @dead hobo: You and I certainly agree on that. I get your point now. I don’t think we really disagree with each other in a fundamental sense.

  31. [...] Letter from Chicago: F A good read.. with this gem The math/science majors meant that I was obligated to take humanities and other (non-science) course work. So I signed up for (amongst other courses) Economics 101. It took all of ten minutes into the first class for me to recoil in horror. I asked the prof: “What do you meant that humans are rational? That is obviously not true. How important is this idea to economics?” The response was, in hindsight, not a surprise: “It is the fundamental building block for all of economics. If you fight that underlying concept, if you do not provisionally accept that premise, you will not be able to understand what comes later.” [...]

  32. spencerh says:

    It extends further than that. Just look what happens when we say that people are irrational and aren’t always in control of their actions. Not only does popular microeconomics implode, but so do our legal systems. If you really dig deeply, and ask a judge or a prosecuting attorney if they think people are always rational, and always responsible, what’s their honest – I mean really honest – answer going to be? “Of course they aren’t, but our whole society falls apart if we don’t maintain that illusion.” Suddenly, anyone can say they weren’t in control. The voices made them do it. Sometimes this is true, other times it isn’t. If our default position isn’t “people are rational” we need to rethink everything, and we wind up starting down the road of things like medicating the population a la THX-1138.

    I’m not attacking or defending a position here, because it’s a very tough topic without the development of certain technologies. Ultimately, our answer lies in creating systems to allow irrational people to exist and behave whichever way while minimizing harm – societies administered by dispassionate friendly AI, for example.

    For economics, luckily, the answer is simpler: abandon the idea of Homo Economicus and adopt systems built on the idea that humans aren’t rational. Heterodox economics has a lot to contribute here, and is the place we should start building from, IMO.

  33. dead hobo says:

    Mannwich Says:
    January 5th, 2010 at 5:39 pm

    @dead hobo: You and I certainly agree on that. I get your point now. I don’t think we really disagree with each other in a fundamental sense.

    reply:
    ———-
    I didn’t think so. I just used your comment to make the point public. People are rational. Those who don’t understand people confuse the concept of ‘rational’ with some fantasy of perfect knowledge applied in a universal context. People are rational. They know when they are being fucked over and can’t do anything about it. They can also be fooled and often trust the wrong people for a while.

  34. Mannwich says:

    @dead: OK, we disagree then. I don’t think most people know they’re being fucked over most of the time. I really don’t. Whether that’s due to irrationality or plain stupidity, I have no idea. You choose.

  35. dead hobo says:

    Mannwich Says:
    January 5th, 2010 at 5:48 pm

    @dead: OK, we disagree then. I don’t think most people know they’re being fucked over most of the time.

    reply:
    ————
    I guess that’s the definition of sheeple.

  36. Andy T says:

    Yeah, but most of the “beliefs” people (maybe even you BR) have on money are rooted in the Friedman monetarist school of Chicago. A lot of people still believe that the Fed “controls” money creation through Base money and the fractional reserve banking system, even though those theories have serious flaws. So, the Chicago school is “embedded” in most places of study and finance in the world. They maybe circling the drain, but some of the theories are institutionalized….

  37. call me ahab says:

    lest anyone not understand-

    Ritholtz is a Keynesian- he admitted as much the other day-

    all good though- increasing the deficit three fold to “jump” start the economy and save the banking system and to run trillions in the red indefinitely is perfectly rational- lol

    “America- borrowing our way to prosperity”

    ~~~

    BR: What Is aid the other day was that I was agnostic, and I will use anything and everything that can be demonstrated to work — whether that means using both fundie and technical data during investing decisions — or when it comes to the economy, using stimulus, tax cuts and monetary policy.

    Although misquoting me makes your argument easier, it was simply not the case.

    I believe pragmatic technocracy makes more sense than any ideology — although not being able to label a position makes it that much tougher for some people (Austrians!) to argue against, it is what it is.

  38. Matt P says:

    I know that beating up on EMH is the flavor of the month Barry, but listing 5 dudes out of 10,000 or whatever people who manage money is hardly impressive. I’m surprised you didn’t list Miller…oh yeah, he tanked eventually. In fact, if you weren’t in his fun on year 1 or 2 of his run (when it was tiny and no one knew of him) then you were a net loser. PS. As of a month ago Simons was badly under performing recently and is retiring.

    ~~~

    BR: The medallion fund had another ginirmo year

  39. whskyjack says:

    Rational: having or exercising reason.

    using that definition, are people rational?
    No, people rarely make a conscience reasoned decision most of the time and many don’t even do so when they are trying too.
    I first observed this when farming markets are subject to floods of irrational players during good times and they disappear during bad, Inners and outers. All no doubt thought they were doing so for rational reasons and could tell you why but they all were operating on “gut instinct” and driven buy greed.

    Jack

  40. HarryWanger says:

    Hey BR: Over at Marketwatch I read a quote from you regarding the Treasury buying equities:

    “The idea that this is magic is nonsense,” said Barry Ritholtz, market strategist at Fusion IQ and a market veteran. “This was a normal behavior in a recessionary bear market. We saw the Dow plunge 5,000 points in 6 months, which had never happened before and created a dramatically oversold market.”

    I agree with part one but I gotta say, when you call this normal behaviour then say “”This was a normal behavior in a recessionary bear market. We saw the Dow plunge 5,000 points in 6 months, which had never happened before and created a dramatically oversold market.” Isn’t that a contradiction? I mean, if something never happened before how could it be “normal behavior”?

    ~~~

    BR: The quote is off a bit —

    I was trying to draw a distinction between a recession bear market and a secular bear market. It was the two. As I have said in the past, we had an ordinary recession bear market from October 2007 to September 2008 — about 20%, about 8 month. What followed — a 5000 point, end of the world, panic sell off — was not ordinary !

    When you lose 5000 points in 6 months, you set up a major snapback rally — very similar to 1973-75

    This chart helps to show the difference:
    DOW 2007 - 09

    Its from here: Recession Bear Market vs Armageddon ?

  41. jeg3 says:

    I took Economics 101, but ended up with a lower grade because I
    refused to put the incorrect answers the professor was looking for.
    Needless to say that was the only pseudonomics course I took.

  42. call me ahab says:

    “This was a normal behavior in a recessionary bear market. We saw the Dow plunge 5,000 points in 6 months, which had never happened before and created a dramatically oversold market.”

    dont’ you understand HW- that means- the Fed needs to address the oversold market and buy equities either outright or through intermediaries- trying to repair the TBTF banks balance sheets in the process-

    of course- perfectly normal- lol

    happens all the time

  43. Agent Smith says:

    This discussion on ‘rational agents’ reminds me a lot of my days in graduate school in Computer Science where modal logics where often used to try to model state information about Knowledge and Belief, e.g. Kp ( I know p ), Bp ( I believe p ), KBp ( I know I believe p), BKp ( I believe I know p), K~Bp ( I know I don’t believe p), B~Kp (I believe I don’t know p ) and so on.

    In this way, you could represent rational agents that held contradictory beliefs, although each was acting rationally according to what they believed. Accordingly, even ‘crazy’ people act act rationally, if by rational you mean following their own set of beliefs.

    However, there was no global sense of ‘rationality’, or any built-in idea that any collection of so-called agents would act to optimize the system as whole in any way.

  44. Greg0658 says:

    spencerh – thanks for the interesting leads
    .. THX-1138
    http://www.imdb.com/video/screenplay/vi3864002585/
    &.. Heterodox economics
    http://en.wikipedia.org/wiki/Social_credit

    as for the onT discussion – I’m in the camp “the system made me do it” .. not that humans are totally rational or not (which we aren’t) we’re still animals genetically / instinctively

  45. DM RTA says:

    ideologies offer perspective not necessarily instruction….price tends to peak after momentum….generally. Momentum confounds one orthodoxy and creates problems for its own followers. Orthodoxy is where the trouble begins…

  46. Rational Expectations says:

    This whole debate has been played out endlessly in academic social science. Rationality is a construct. No modern economist believes that humans are literally rational. The requirement is that you assume that people have preferences and then that they seek to realize them, imperfectly, with errors and uncertainty, and budget constraints. A smoker prefers short term benefits to long-term gains, even if expectationally, he or she should not. This is “rational” if by rationality you mean “good judgement.” It is rational if rationality is a way of connecting preferences — whatever those preferences might be — with behavior.

    When Barry says that people aren’t rational, he has in mind a certain set of things that people ARE. Whatever people are in their preferences, there needs to be some way for academics to connect these claims with conclusions about human and social behavior. The behavioral “revolution” in economics is really an evolution. Research is providing a richer set of claims about human and social preferences. They still use the same construct, assuming that people try to realize their preferences. Try doing the opposite!

  47. Uchicagoman says:

    Barry,

    Physics major, a?

    Well, me too.

    For ever action there is an equal and opposite reaction, no?

    The world is actually composed of discrete energy levels and interactions dictated by probability, no?

    Some of the interactions and energy levels are incredibly unlikely, but still possible, right?

    And all of these things are interacting with each other all the time in a hugely complex system.

    But what do we see most of the time, on a larger time scale and distance?

    I would say a fairly predictable distribution, making up a larger whole, .. of which can never remain in a state of apparent “non-equilibrium” forever.

    I think there are parallels in this to what EMH is getting at.

    The point is there is a distribution.
    And there are winners and loser. Energy is not created out of nothing.

    Not every one can be a Soros. It is simply impossible.

    And there is a distribution of what one might call “rationality”. Not everyone is Einstein, nor is everyone a law abiding citizen.

    But, we know that in an at least semi-honest market with some justice and rules (albeit, with much to desire), such things cannot last forever, (see Bernie Madoff).

    If markets were not sufficiently efficient (and stochastic) in nature, then your job could not exist. At least not honestly.

    But isn’t that the real trick of the finance world? Using other people’s money to gamble with..charging them huge fees all the while.

    Now that is a rational business model it any!

  48. km4 says:

    Economists assert they know how things work based on manipulated statistics and biases then provide policy recommendations based on that so-called knowledge but in reality they refuse to admit that they really don’t understand what is going on.

    They are bloviating posers and pretenders !

  49. RonN says:

    I too majored in physics and applied math in undergrad school back in the late ’60′s and took Econ 101 as a sophomore. Like you, I questioned the “rationality” premise, but stuck with the course mainly to prove to my econ/biz major roommate that I could “ace” the course – which I did, getting the highest grade for the semester. I went on to get a PhD in physics and EE at the Univ of Illinois and over my career worked with numerous physics and chemistry Nobel prize winners. My interest in econ and biz took me “out of the lab” (at Bell Labs) into management and I later was CEO of several silicon valley startups. In my “semi retired” mode about 18 months ago, I started reading econ books to catch up on rational market debunking, behavioral econ and investing, including Shiller’s Irrational Exuberance. That led me to fire my Morgan Stanley wealth advisor and move out of the market in Aug ’08 and then short it on the way down. A “just in time” return to the issue of rationality of individuals and markets!

    BTW, I greatly enjoy your postings and perspective! And I love your music recommendations. What about the Doors “Live in NY”?

  50. cognos says:

    UChicagoman — Good points there. EMH is very important for my mothers pension fund or even for the average HNW investor. William Sharpe was onto a great truism when he said, “the average investor cannot beat the average return”.

    Too bad that is often muddled into — “all should index” … there are many ways to fleece the indexers.

  51. robcyran says:

    I wish I had been as quick witted. Took me until grad school to figure out the emperor was bare assed.

    Two comments stuck out
    1 – One professor seriously said, “there’s no such thing as society”. This caused me to giggle.
    2 – Another said, “your argument is boring – it doesn’t have any math” and then proceeded to tell me that I should add a fancy econometric model on completely ludicrous assumptions. He didn’t like it when I mentioned Woody Allen’s quote that it’s better to be vague than wrong. (I shelved my PhD plans shortly afterward)

  52. Wes Schott says:

    …the horror,

    where are the Austrians?

    Q: What is the difference between an Austrian economist and a positivist?
    A: Austrians positively recognize that humans act subjectively!

  53. Byno says:

    “EMH does not permit consistent out-performance by managers, so it therefore comes up with half-assed reasons why Jim Simons, George Soros, John Paulson, Steve Cohen have not trounced the averages over their career. “Must be dumb luck” they dumbly rationalize.”

    From Carl Sagan’s The Demon Haunted World: “The Italian physicist Enrico Fermi, newly arrived on American shores, enlisted in the Manhattan nuclear weapons Project, and brought face-to-face in the middle of World War II with U.S. flag officers: So-and-so is a great general, he was told. What is the definition of a great general? Fermi characteristically asked. I guess it’s a general who’s won many consecutive battles. How many? After some back and forth, they settled on five. What fraction of American generals are great? After some more back and forth, they settled on a few percent. But imagine, Fermi rejoined, that there is no such thing as a great general, that all armies are equally matched, and that winning battles is purely a matter of chance. Then the chance of winning one battle of one out of two, or 1/2; two battles 1/4, three, 1/8, four 1/16, and five consecutive battles 1/32 — which is about 3 percent. You would expect a few percent of American generals to win five consecutive battles — purely by chance. Now, has any of them won ten consecutive battles…?”

    It’s not dumb luck; it’s basic statistics, and creating a straw man doesn’t change the fact that Dr. Simons, Mr. Soros and Mr. Buffett should exist under all matter of statistical distributions. Saying that EMH doesn’t allow for outperformers to exist is like saying a Roulette Wheel doesn’t allow three 9s in a row. Further, it doesn’t hurt that some hedge fund managers are using 10x leverage in their portfolios so long as they don’t screw up. Of course that happens from time to time to, as a certain Red Sox owner can attest, to use but one example.

    It’s not that the underlying premise of EMH is wrong – chiefly, that the stock market is nearly impossible to outguess – but rather that some of its adherents mistake mean reversion for perfect information and rationality. Can you beat the market with inside information or fundamental analysis? Sure, so long as only a few people have that info. But that edge you think you have doesn’t last forever, whether it be size constraints, shifting fundamentals, government regulations, etc. changing the landscape.

    How many hedge funds closed in the last two years? How many funds have we watched implode where we wondered whether or not monkeys armed with darts couldn’t have performed more competently? If outperformance is a knock against the idea that beating the market is a function of luck more than skill, is not underperformance a tick in said idea’s favor? Well, no, actually both are arguments for the premise, as such is the nature of tails.

    Winding up this incredibly long-winded post, if you wanna dog out LTCM for suffering from a glorified version of gambler’s ruin, be my guest. Humans are not always rational either. Finally, some people do actually beat the stock market. But if markets are so inefficient, why do so many people do worse off than they would in an index fund (and don’t say market timing either; were they to stay fully invested they’d lose to the S& 500 80% of the time)? Why do so many mutual funds fail or underperform? Why are you at least as likely to lose a pile of money in a hedge fund as break the bank? And if John Henry, Bill Miller, Eddlie Lampert, Julian Robertson etc ad nauseum were such geniuses in the past, was it “just dumb luck” that they fizzled?

  54. Economics is different from all other sciences. Most scientists rely on facts. Economists tend to rely on popular wisdom and scare phrases, all unsupported by details or facts.

    An example is the article titled, “Deficit, Budget Woes Need Solutions as U.S. Nears the Precipice,” written by Mark Whitehouse for the January 4, 2010 Wall Street Journal. He quotes “four prominent economists” – Alan Auerbach of UC Berkeley, Robert Barro and Martin Feldstein of Harvard and Tom Sargent of NYU – all of whom agree we are near the “precipice.”

    We never are told specifically what the “precipice” is, although we are given some generalized scenarios, for instance: “Mr. Auerbach estimates by 2026 the U.S. public debt will exceed 108.6% of GDP.” The debt/GDP ratio is completely useless*, a nonsense ratio signifying nothing. No, it does not measure the government’s ability to pay its debts, which it pays by creating money ad hoc. Nor does this ratio measure the health of the economy. Japan’s ratio is about 200%; Russia’s is about 10%. Which do you prefer?

    Debt is a many-year, cumulative measure of total federal money created; GDP is a one-year measure of goods and services created – a classic apples/oranges comparison. Although the lay population doesn’t understand it, any credible economist should know this.

    Then we are told, “To make matters worse, the ‘trust funds’ the government has set aside to pay Medicare and Social Security benefits will be exhausted by 2017 and 2037, respectively, after which a big chunk of benefits will have to be paid from current taxes.” First there are no “trust funds.” There only are balance sheet notations, which the government controls. Second, the government does not use tax money to pay its bills. The government pays its debts by crediting bank accounts and debiting balance sheets, which it can do endlessly. It does not spend tax money. When tax money is received it is destroyed. Again, the lay public doesn’t understand this, but any economist should know it.**

    The article goes on, “If investors balk at buying the Treasury bonds the government issues to cover its deficits, they could force it to slash spending arbitrarily and provoke a spike in interest rates that would strangle the economy.”

    Where to begin with this one? First, the government does not need investors to lend it money. The federal government borrows by creating T-securities from thin air, backed only by full faith and credit, then selling them for the money it previously created. The government just as easily and safely could create money from thin air, also backed by full faith and credit. This is where federal money originally came from. Eliminating the borrowing step would eliminate all concerns about debt. Federal borrowing is a useless relic of the gold standard days.

    Second, ever since we went off the gold standard in 1971, the government has had the unlimited ability to create money to pay its bills. No amount of debt could “force the government to slash spending.” Were taxes to fall to $0, and deficit spending to triple, the government’s ability to pay its bills would not change even one cent.

    Third, since borrowing is unnecessary, Treasury buyers cannot set interest rates. The rates are set arbitrarily by the government, and always are exactly what the government wishes them to be.

    Fourth, there is no historical relationship between interest rates and economic growth. High rates do not “strangle the economy,” nor do low rates stimulate it. *** The Fed found this to its chagrin when it lowered rates 20 times, in a fruitless effort to stimulate the economy. Interest rates are a minuscule part of business expenses, and for every borrower there is a lender. To the degree high rates hurt borrowers, they equally help lenders. High rates actually have a slightly stimulative effect these days, because they force the government to send more money into the economy.

    The article then says, “The U.S. can’t cut its deficits immediately, lest it snuff out a nascent economic recovery.” True. But then, the article says, “Economists estimate that to pay down its debts in the long term, the U.S. Government needs to cut spending or raise taxes by a total of as much as 9% of GDP.” Huh? Cutting deficits will snuff out the recovery, but we need to cut deficits to help the economy?? Madness.

    Oh, it goes on: “ . . . increasing taxes on consumption . . . would have the added benefit of encouraging Americans to save. . . “ If anyone could explain how taking more money out of people’s pockets will encourage them to save, I’d love to hear it.

    Finally, Mr. Feldstein reportedly believes Americans should finance a portion of their own Social Security and health care costs – “an approach the Bush administration unsuccessfully attempted with Social Security.” Can you believe it? This “prominent economist,” having just witnessed the collapse of the stock and real estate markets, still thinks people should invest to finance their own health care and retirement.

    And this is why economics is different from other scientists. Can you imagine a prominent physicist mouthing such unsubstantiated, populist nonsense? No wonder people have such a low opinion of economists. Truly sad.

    Rodger Malcolm Mitchell

    *http://rodgermmitchell.wordpress.com/2009/11/08/federal-debtgdp-a-useless-ratio/

    **http://rodgermmitchell.wordpress.com/2009/12/17/how-the-federal-deficit-really-works/.

    ***http://rodgermmitchell.wordpress.com/2009/09/09/low-interest-rates-do-not-help-the-economy/

  55. Economics is a science?

    I beg to differ!

  56. alfred e says:

    @BR: At least once a year you take great delight in dissing the “Chicago School”. And then we get more tidbits about your reaction to your being a physics major. Exactly how long were you a physics major and where? Equestrian seems to come up as your most important interest.

    The U of Chicago is more than one school. At it’s deepest most fundamental level it teaches people to think. And it is one of the best in the world at that. Far, far better than the Ivy Leagues.

    And I’ve made these comments before. Particularly with regard to Friedman.

    Thinkers are invaluable because they challenge others to think. On a good day. It’s not exactly their fault their thinking may become dogma.

    Someone else has to step up to the plate and prove them wrong.

    That gets fucked up when money becomes involved, and vested interests. Which IMHO is paramount to what is happening to U of C Business School. First the new downtown campus and then the Gleacher Center, and the new campus building, and most recently the name change to Chicago Booth.

    And as Dean Snyder, who is now retiring/resigning, likes to point out, we are in an era of entitled students, which makes learning irrelevant.

    Frankly I think they lost their way when they started telling important people what they wanted to hear, and not what they needed to hear.

    As in: there is no recession, which is one of the few times I took issue with their public pronouncements.

    There was absolutely no thinking behind that.

    Just currying favor.

  57. davossherman@gmail.com says:

    Bernoulli’s Law doesn’t make plane fly either. I logged 15,000 hours, most of which as an airline company instructor and airline check airman, and line captain before finding out Newton’s Third Law, or what I assumed at age 5 after my first flight, made planes fly.

    Smart people without common sense are book smart brilliant, entertaining to listen to and read, but give them something to apply their errant logic to and they become a bunch of misguided fools.

  58. johnborchers says:

    ““What do you meant that humans are rational? That is obviously not true. How important is this idea to economics?” ”

    While you are around you meant mean and it was probably a really good move to drop the class otherwise you might have been turned into another monkey and we have enough of em.

  59. TakBak04 says:

    BR…I didn’t quite understand your post about “walking out of Economics 101.” Maybe because I went to a low grade school in the Southeast US…and as an English Lit Major was required at that time to take “Econ 101″ as basic before I got into my major (now this is years ago before you) that I somehow escaped the “Chicago School” theory being indoctrinated into “Economics 101.”

    I found in my “low grade Southeastern School” that “Econ 101″ was basically: History of Markets from the beginning of America down through the centuries with the crises in markets and culminating with the “GREAT CRASH/DEPRESSION.” The course talked about what had been done about these crises…role of banks, Capitalism and how money works and why we need to use money and why governments need to use money to help the people and businesses by lending.

    Maybe that I was in such a “Tier 4 School” in the Southeast I managed to escape the GREAT CHICAGO SCHOOL of Milton FRIEDMAN…SUPPLY SIDE.

    Maybe they just taught the “basics” to us English Lit Majors figuring we needed an “Overview” and not some intense course in “Theory of Economics” but just practical, down-to-earth basics.

    Gotta tell ya’ though. That course in ECON 101 has served me well! I’m here posting on your site because I had enough interest that I learned stuff on my own through investing through the years…even as an English Lit Major…from a sub-prime college.

    Let’s just figure that different folks are exposed to different stuff and that “Thank our Stars” the Mighty Word of Friedmanomics didn’t infest every corner of America and that us “English Lit Majors” might have been nimble enough in mind to sort it all out through the years and come out okay in the end.

    :-)

    It’s amazing how it all sorts out….isn’t it?

  60. Uchicagoman says:

    @alfred e

    Names,buildings, and money aside, Mr.Booth is at least returning the favor for fortunes built upon the principles learnt while a Chicago.

    In fact, his mentor was Eugene Fama himself. The source of EMH.

    …And the theory on which his company, Dimension Fund Advisors, is centered on:

    http://www.dfaus.com/

  61. Uchicagoman says:

    correction:

    *Dimensional Fund Advisors

  62. TerryC says:

    I can PROVE that the Chicago School is correct when they say humans are rational. The Las Vegas economy in solidly built on, uh, let me see, oh well…. never mind.

  63. Space_Cowboy_NW says:

    a)”A good plan violently executed now is better than a perfect plan executed next week. ”

    b)”Moral courage is the most valuable and usually the most absent characteristic in men.”

    c)“Good tactics can save even the worst strategy. Bad tactics will destroy even the best strategy.”

    Perhaps Paul Volker would have shared a similar avenue of thought with Gen George Patton?

    RE:davossherman@gmail.com Says:

    January 5th, 2010 at 7:47 pm

    Bernoulli’s Law doesn’t make plane fly either.

    Correcto, as $$$$$ makes the plane fly
    (besides converting dead dinosauers remains to a heat/thrust component)

  64. Brendan says:

    Way to get the libertarians all riled up! How dare you imply that the entire does not revolve around rational decisions made only with money and things that can be assigned monetary value!

  65. Brendan says:

    *entire world* – way to check my work!

  66. Mannwich says:

    Seems as if we paranoid types aren’t the only ones who believe there’s a PPT in action. Seems to be gaining some attention these days even from MSM outlets.

    http://www.marketwatch.com/story/time-for-fed-to-disprove-ppt-conspiracy-theory-2010-01-05

  67. MayorQuimby says:

    Economists are at the “the world is certainly flat” stage. Some of them are so confident that they stomp up and down and demand that people never consider that it isn’t. They will all be both humbled and embarrassed over time.

  68. crosey says:

    So BR, when you dropped Econ 101, did you add Chaos Theory?

  69. [...] at 10:35 am | After dominating economic academia and nearly pushing Keynes out of the curriculum over the last 30 years, it’s good to see that the Chicago school is dying out, as its tenets and teachings were in [...]

  70. Transor Z says:

    I hated macro and micro and blew both off but wasn’t sharp enough at that age to realize why (because they’re BS).

    If you believe Daniel Dennett, people are soulless meat computers who behave according to wetware programming. Whether they seem to behave “rationally” in a given situation might say as much about the observer as the people being observed. We’ve only been sitting in front of computers soaking up charts and spreadsheets and IMs and financial TV with screen crawls and graphics for an eyeblink.

    To decode behavior you have to understand the wetware applications that are installed and running. That’s beyond our abilities now because people are individually and collectively hugely complex systems. Behavioral economics is at least a step in the right direction.

    Another interesting thing is that we are evolved to function in an environment of incomplete knowledge. If you really want a leg up on markets, you might be better of genetically modifying your olfactory sense so that you can smell fear and/or sickness like dogs can. You could walk into a board meeting and know with greater certainty that some people at the table are shit-scared but putting on a good face (i.e. lying).

  71. Matt P says:

    Well said Byno….

  72. An engineer, a physicist and an economist are marooned on a desert island, but luckily a can of beans has washed ashore. The three argue over how to open it. The engineer says they just need a sharp rock to crack the can open. The physicist argues they should heat the can over a fire until it explodes. The economist says, “Now. Assume we have a can opener… ”

    Tying that into crosey’s comment above, I first read that joke in Mandelbrot’s (Mis)behavior of Markets.

    Microcap, I think there’s somewhat of a difference in meaning: In a way, rationality assumes away all other reasons market participants could make a decision in favor of the particular reasons the economist has assigned to the model. Irrational isn’t necessarily an opposite of rational, to me it means we make decisions based on factors beyond personal gain…

  73. aaannd… I guess I was responding to a reply that got deleted. Anyways.

  74. Great post, Barry. The interactions between humans are incredibly complex and full of near infinite possibilities. They are surely not rational (Cf. emotional) all the time. And those who attempt to live by a black and white model of reality always end up eating crow … or worse.

    Keep up the great work!

  75. [...] to London, could it be that the Chicago School has entered a period of terminal decline? Let us hope…. Why is the Chicago School of Economics such an intellectually bankrupt line of thinking? It [...]

  76. Julia Chestnut says:

    It was exactly this stupid nonsense about all actors being rational that drove me out of economics — and I had a minor at the undergraduate level and did a lot of masters coursework in it. Enough to take advanced micro and econometrics. This and the Church of Free Trade are the two ideas that I simply could not stomach: “free trade” is just a nice way of saying that you make everything negative or difficult to measure about asymmetry and degradation into an externality, and march merrily along.

    The price of that melamine plate from China is low because it does not include the true costs. How the hell does that make the world better off?

    I did graduate work in attempting to value the quality of inputs usually not considered scarce — CLEAN water, CLEAN air, the price of species collapse and destruction of genetic diversity as fisheries are overfished and destroyed. But at some point, I just couldn’t keep the cognitive dissonance going. It’s all a crock, and it is the most basic assumptions of economics that make it a crock.

    Needless to say, I’m now a lawyer. ;)

  77. walons says:

    But isn’t it a little unfair to single out the Chicago school as the main rationality culprit here? Some kind of rationality was assumed by classical economists well before UC even existed, no? Maybe you are saying that Chicago took this to excess.

  78. bman says:

    I agree people are irrational. We as a nation went to market with a gun in hopes of getting cheap oil about eight years ago, and oil prices subsequently balooned you can argue that we didn’t actually hope to get cheaper oil, or we didn’t actually go to the market or whatever, I don’t care to hear it, you can talk to the curve.

    Today you can still buy an F150 hoping to feel safer with respect to the insane person driving down the road next to you, I heard it on TV just the other day! That type of mentality should be taxed to oblivion.

    It’s a junkie of some sort or other who gets the bright idea to go to the market with a gun. Face it this country is on life support, you can try to pull out the IV’s if you’d like. How long will it take us to wake up and look in the mirror? Every town and city across this country is in survival mode if not in active collapse. In my opinion it’s too late, we’ve been in denial for at least the last eight years.

    This post got deleted last night, I’ve tried to recreate it here, but work calls, sorry for the lack of elequance.

  79. Yossarian says:

    So, Barry, what exactly do you support in terms of policy? Are you in support of “rational” Keynsian tax and spend policy when irrational individuals make the irrational decision to save? Are you in favor of a single “rational” entity to manage the economy? How would you structure such an entity so as to defend us from all the irrational humans? What exactly do you stand for and against?

    Do you acknowledge that you should revise this post in light of new information?: http://www.ritholtz.com/blog/2009/01/karl-roves-revisionism/

    Or are you so married to the claim that Chicago School critics of FNM/FRE/CRA are 100% wrong in their criticism of these entities/policies that you are going to bury your head in the sand rather than entertain a new line of thought? There is no silver bullet explanation of the financial crisis but sure FNM/FRE/CRA played a part.

    http://online.wsj.com/article/SB20001424052748703278604574624681873427574.html

  80. Swampfox says:

    There seems to be a bit too much people are rational or they aren’t going on.

    One should figure out human nature (rational at times, emotional at times, capable of being a beast or an angel, etc.) and then build theories on economics, politics, etc. from that point.

    Frankly, I believe people act in self-interest influenced by reason and emotion, often at once. It’s a good starting point for economics.

  81. Blunt Instrument says:

    Barry, perhaps you walked out of the class on Probability and Statistics as well. Byno has covered why your argument against EMH based on a few anecdotal exceptions fails. I am skeptical of your analysis because it appears to be self-serving. Noone who puts food on the table and cool cars in the driveway based on their ability to beat the market will admit to themselves or anyone else that most would be better served by a buy-hold-and-outlive strategy. It wouldn’t be ‘rational’ for you to behave any other way.

    However, some of your problems with EMH (and economics as a whole) may stem from confusion regarding the definition of “rational.” In economics, “rational” does not mean logical or without emotion. “Rational” in economics means that a person makes choices that seek to maximize a utility function. These utility functions are necessarily subjective. Your utility function of greater health and longevity would not be maximized by smoking. However, a teen who feels invincible may be quite rational when they maximize their status and ‘coolness’ factor by lighting up. A person who does not wear a seatbelt may be maximizing comfort and convenience over safety. Either way, it was their choice . That people choose to maximize utility functions that are different than yours does not make them “irrational”. Because people do not understand finance and make poor decisions does not make them “irrational”. As long as they are making reasoned choices that seek to maximize, they are rational.

  82. I never bought that statistical distribution model excuse either.

    If some people should out perform for some years, and a handful of people about perform for even more years, explain Jim Simons Renaissance Technologies outperforming for over 30 years. The claim it is within the statistical distribution is a nonsense answer. If anyone accepts that explanation, you get to defacto define away all outperformance, thus making the EMH thesis impossible to disprove (at least in terms of outperformance) .

    Next up: Please have EMH explain bubbles and collapses as well.

  83. Roger Bigod says:

    You guys think too much. I get top grades in my econ courses, and the secret is it’s all equations and graphs and stuff. Just like math and physics except better job possibilities.
    Somebody should set up a Nobel Prize in math or physics. They’d get more respect when they got quoted and people would take them more seriously. It might take away a little from the one in Economics, but hey that’s an externality.

  84. Moss says:

    Markets are efficient during periods of great moderation when all participants act rationally. LOL

    When I hear Larry Kudlow proclaim that the nearly 1 trillion in stimulus has had little to no impact on the GDP I chuckle and shake my head. Ideology clearly muddles one’s mind and political affiliations have a lot to do with ones’ economic ideology. Or one could say economic ideology has a lot to do with one’s political ideology, take your pick same difference.

    Let the sludge proceeded to the drain and beyond to the sewage grave.

    Hey at least we got rid of Dodd.

  85. Paul Wilkinson says:

    Barry, in my comment that fell victim to your glitch, I wrote something about the desire to maximize utility causing the sell-side to try to hide the crap in ABS and causing the buy-side to want to buy the ABS crap for the simple reason that they saw other people beating their returns by doing the same thing. The EMH is flawed to the extent there’s information asymmetry that let’s such behavior run wild. The EMH worked ok for many years after public companies started reporting U.S. GAAP results because until the Enron SPE’s, the WorldCom fraud, and the ABS complexity, the benefits of adequate GAAP disclosure tended to outweigh the costs of residual opacity and irrational mania (i.e., the dot com bubble). With ABS, there was no structured disclosure comparable to GAAP. (There is now — see http://paulwilkinson.com/2009/12/10/xbrl-data-tagging-standards-advance-on-two-fronts/#econtrans — there’s just not the will to mandate it.) Yes, GAAP is far from perfect, but it’s interesting to note that the worst crisis financial crisis since the Great Depression was connected to trillions in notional wealth that was basically exempt from GAAP.

  86. Yossarian says:

    Even the freest of free markets are somewhat reflexive and will be subject to manias and crashes and revolve around some fluctuating, yet generally unpredictable equilibrium. But very few aspects of our economy are completely free so there is room to profit as the rules change. But for every Jim Simons there is some quant day trader blowing up as they strive for Renaissance returns. Eventually the Renaissance returns will be eroded (by GS maybe?) and it will be time to find a new inefficiency.

    But what is your point? If your point is that we don’t have perfectly efficient markets I would have to agree. However I would not that as the markets become more free, and the institutional barriers that create inefficiency fall, we approach the EMH assumption even if we never really get there. And if you don’t buy that then what is your alternative? A more regulated market will be more efficient than a market with less but smarter regulation.

    Let me guess, you would be the regulator who would make everything efficient? Or would it be Barney Frank and Chris Dodd who, along with a few Republican clowns, oversaw the completely benign and innocent Fannie Mae?

  87. Yossarian says:

    Should have read: “…a more regulated market will be less efficient”

    And neither the Chicago, Keynesian, nor Austrian Schools incorporates fraud into their theory and I think we can all agree that there has been and continues to be serious flaws occurring on a daily basis in our economy, whether they are prosecuted or not. So, yes, you can earn extra-normal returns by pushing the ethical and legal bounds. Cough. SAC. Cough.

  88. DiggidyDan says:

    My post got lost in the shuffle or erased. . . to reiterate:

    You all are arguing the wrong point and missing the “Big Picture.” The point isn’t whether or not humans are rational beings, it is that economic markets are COMPLEX ADAPTIVE SYSTEMS, and therefore cannot be accurately modeled based on limited assumptions, such as “all humans in aggregate will tend toward rational behavior.” Therefore, of course the Chicago school is wrong in their models. . . but SO ARE ALL THE OTHER SCHOOLS MODELS.” There can never be a correct MODEL, because YOU CAN”T MODEL A COMPLEX ADAPTIVE SYSTEM. There can only be a “LESS INCORRECT” approximation. Read the work of Beniot Mandelbrot for a better explanation of this: http://www.amazon.com/Misbehavior-Markets-Fractal-Financial-Turbulence/dp/0465043577/ref=tmm_pap_title_0

  89. Darkness says:

    Barry: “We know that seat belts turn minor crashes into mere inconveniences, and major crashes into survivable events. Why do 25% of US drivers not wear their seatbelts?”

    Well, because the nanny state told them to and they are stuck in flash backs from being five years old and can’t stand to comply because they’d hate themselves even more if they did? Being stupid on your own terms has short term ego rewards that trump all else, and are ergo “rational” for some dimension of rational yet to be defined.

    I’m not defending the Chicago School, by any means, but I would argue that people THINK they are being rational when they buy something. In truth they are acting on impulse that is later “rationalized” to their own satisfaction and if that fails they suffer buyer’s remorse. Where economists fall down is assuming they can understand these myriad actors’ rationality let along represent their emotional impulses in a model.

    curbyourrisk: “…someone who believes in the Chicago School, walk don’t run to the registrar and switch to a different econ professor. ” I think you mean……RUN don’t WALK….

    Unless you are carrying scissors . . .

  90. Tony61 says:

    Actually Ptolemy knew the earth was round; his error was that he thought that the center of the solar system was the earth (geocentric) instead of the sun (heliocentric).

  91. EdSez says:

    When I was going to University of Chicago, I was breezing through an Econ midterm. I came to an essay question that showed an apparent anomaly between the facts for two car companies and their relative stock price and asked whether the market priced it correctly. I said the market was wrong (which is the ultimate sin at Chicago) and gave an explanation that seemed pretty tight to me and used some other theories in the class. The TA who graded it gave me zero points and said ‘This answer is particularly disappointing given the rest of your exam’.

    What he was really telling me was that he knew that I knew what I was supposed to say and it would go better for me if I always said it. So, I did my arguing about EMH at the pub, but always adhered to it on exams from that point on. That was the way to succeed at Chicago.

  92. SiValleyEE says:

    The worst “assumption” I’ve experienced is in the intro to the early versions of Steven Covey’s “The Seven Habits of Highly Effective People”. He said that our country’s early leaders were of high integrity and extremely honest and it served them very well. He said that “therefore” everyone should do the same, and he based significant parts of his book on this assumption. ”

    Covey therefore argues that effectiveness is achieved by aligning oneself to what he calls “true north” principles of a character ethic that he believes to be universal and timeless”. Such as he argues also in his earlier book, “The Divine Center” in which he explains that has discovered how to communicate Mormon truths to non-Mormons by simply changing his vocabulary. [1]

    Nevermind that our country’s early leaders had as much political backstabbing, duels, lying about each other, sex outside of their marriages, and such, as do our current politicians. He must have gotten this feedback repeatedly, since the latest version of the book just describes that, “during the 150 years or so that preceded the 1920′s, the literature on success was more character oriented. It emphasized the deeper principles and foundations of success.” (quote approximate)

    Nothing against the concept of the principles Covey tries to sway people towards, in theory. But in practice, if you follow his principles religiously in the modern corporations, the gameplayers, backstabbers, and credit-takers are going to eat you for lunch. It’s much more effective to treat people how they treat you, with a bias towards treating people how you would like to be treated, rather than following Covey’s advice blindly.

    Yeah, this “assumption” and “therefore” have annoyed me for years.

    [1] Aplogetics index, http://www.apologeticsindex.org/c13.html

  93. LC says:

    Guys, did you see this item in the news?

    Reuters. Chicago, Nov. 17, 2009. The University of Chicago announced today it is outsourcing its Economics Department research and teaching activities to the Indian Institute of Technology Bombay beginning in the Fall of 2011.

    “We fully intend to remain a strong bastion of market-centered economic thinking. Our commitment to the students and the economics program is inviolable,” said President Robert Zimmer in a statement released today. “Students enrolled in economics will not see any diminution in the caliber and quality of teaching,”

    “Rather, the same high quality coursework will be delivered via state of the art conferencing centers on campus and the Internet.”

    “This is a big opportunity for us to leverage our faculty strengths and influence mainstream economic thought,” said K. Jain, head of the IIT Bombay Shailesh J. Mehta School of Management.

    A Chicago University spokesman added that students will receive a University of Chicago degree with an IIT superscript for their major recognition (Economics UChIIT).

    The move was prompted by the realization that IIT Bombay had a major comparative advantage over the University of Chicago in delivering high quality economic education and research at lower cost. “Our professors can earn much more money in consulting than in teaching. Once we recognized that, and given the technological capabilities of the Internet, we had to make the move,” said President Zimmer.

    “IIT is one of the most rigorous institutions of higher learning in the world with an outstanding faculty in economics and a track record of turning out quality economists, much like the University of Chicago. And their teachers are paid one-third as much as U.S. professors.”

    The savings will be significant to the University, which a spokesman said will help to moderate the growth in tuition costs.

    Non-tenured faculty will be let go at the end of the 2011 spring term. Tenured professors are being offered buy-outs. There has been some grumbling among the younger faculty; and one senior professor was heard to say, “Gee, I never looked at it that way.”

  94. [...] University of Chicago School of Thought Gets an “F” by Barry Ritholtz at The Big Picture [...]

  95. Jeffrey V says:

    I recently read your posting “Letter from Chicago: F” from January 5th, and your story of walking out of an undergraduate econ class. You were curious if anyone else had similar experiences in grad school or undergrad. I was an electrical engineering undergraduate, and I enjoyed the econ classes I took then. However, let me share my experience in a PhD Finance program two years ago.

    I spent the 2007-08 year as a first year student in a PhD Finance program at a Top University. All the classes I took were in the econ department for the first year; I was basically a first-year econ student.

    The financial crisis was unfolding while I was there; one might expect that it would be a very interesting time to be in the graduate econ classroom. I can briefly summarize for you how the financial crisis was discussed, both inside and outside the class room: .

    Nothing at all. The most significant economic and financial event in decades was happening out in the Real World, but it didn’t penetrate the bubble of Academia. Rational expectations and normal distributions were still taught as gospel truth, and woe upon the student (me) who questioned the orthodoxy.

    I still remember a professor advising me that critical thinking is a detriment to learning economics.

    I still remember a professor scolding me that it would be inappropriate to teach anything realistic in his classroom.

    I still remember my advisor yelling at me “Have an open mind! Stop questioning things!” after I questioned the relevance of theory in the face of recent events.

    I am no longer a PhD student, largely because I couldn’t accept the fact that academic economists I met have no interest in understanding how an actual economy actually works; they just enjoy irrelevant and overly-complicated math models.

    On a side note, how did you end up moving from math and physics to economics and investments? I am an electrical engineer with a strong interest in economics and investments; I thought I would really enjoy the PhD program in finance. But since that did not work out as I planned, I am not sure how I could still act on that interest, either within my current job, or doing something new. I am curious to learn more about how you transitioned from one career to another.