Has 'guiding model' for global markets gone haywire?

The global financial crisis is shaking the world's financial system to its very foundations - even its theoretical foundations.

By PINCHAS LANDAU
Martin Wolf 88 248 (photo credit: Courtesy)
Martin Wolf 88 248
(photo credit: Courtesy)
The global financial crisis is shaking the world's financial system to its very foundations - even its theoretical foundations. That was one of the key messages to emerge from the first day of public sessions at the International Organization of Securities Commissions annual conference, being held this week in Tel Aviv. The conference is the highest-level financial-sector event ever to take place in Israel, with delegates from all corners of the world - except the Arab countries, who ostentatiously stayed away and did their best to have the event moved from Israel. The lunch tables at the Tel Aviv Hilton, the conference's venue, offered ample evidence of that effort's failure. A very large Asian representation included delegations from China, Taiwan and South Korea, along with delegates from India and Sri Lanka in South Asia. African representatives from Nigeria, Ghana and other countries mingled with their peers from all parts of Europe and both North and South America. They were all clearly enjoying the Tel Aviv environment and were full of praise for the Israel Securities Authority, which organized the event. But the intensive conference program left delegates little time to bask on the adjacent beach. In tandem with all the major international financial organizations, IOSCO is deeply engaged in an effort to identify the causes of the financial crash of 2007-2009 and to put into place rules, mechanisms and concepts that will prevent similar disasters in the future. The proceedings made clear that the changes being discussed go far beyond regulatory procedures, encompassing the basic concepts underpinning the securities sector. A series of top-level speakers openly called into question the validity of the "efficient-markets hypothesis," which, according to Guillermo Larrain, chairman of IOSCO's Emerging Markets Committee, is the theoretical basis on which rests the regulatory system for global securities markets built up over the last 30 years. The efficient-markets hypothesis posits that if market participants have access to full and timely information, the price discovery mechanism of the free market will result in traded securities reflecting all that information and finding their true, or correct, value. The practical implication of this, for securities regulators, has been that their focus should be - and has been - on achieving full and rapid disclosure of all relevant information, by companies whose securities are offered to the public and traded on public exchanges. In academic circles, this hypothesis is regarded as beyond criticism; so it was no surprise that two leading economic academicians-turned-regulators who were present, Bank of Israel Governor Stanley Fischer and Banca d'Italia Governor Mario Draghi, studiously ignored the heretical opinions being voiced in the discussion they participated in. Larrain, in brief remarks in the opening session, had merely implied that the hypothesis might be open to reconsideration. But the first panel session of the conference saw a much broader and overt assault. Martin Wolf, chief economics commentator of the Financial Times, was the hypothesis's most outspoken critic. In presenting his appraisal of the main lessons of the crisis, he effectively dismissed the efficient-markets hypothesis as a useful basis for understanding how markets function in reality. Paul McCulley, managing director of PIMCO, the world's largest bond-fund manager, devoted more time to discussing the hypothesis and was less far-reaching in his conclusions. The "guiding model of market participants for the past 30 years," as he called the hypothesis, has not failed, but it is seriously flawed, because it does not factor in the key element of human nature. The hypothesis assumes economic actors are rational and act rationally. But, McCulley concluded, the truth is that "markets are efficient and rational most of the time - except when they're not. And when they're not, they behave the way human beings behave, which is characterized by becoming bored and greedy." It therefore seems that classical economic theory is having to face up to the shocking revelation, so clearly exposed by the market meltdown of fall 2008, that the real world is full of people who, when push comes to shove, actually push and shove, rather than conform to the behavioral patterns scripted for them in textbook models.