Oct. 8 (Bloomberg) -- Judging from the preponderance of his utterances, presidential candidate Mitt Romney has a classic Republican approach to financial regulation: Get government out of the way, because markets are inherently wise.
If only it were right.
It’s hardly surprising to see Romney repeating the wisdom-of-markets mantra. His chief economic adviser is R. Glenn Hubbard, dean of the Columbia University Graduate School of Business. Eight years ago, Hubbard co-wrote a paper -- paid for by Goldman Sachs -- proclaiming the arrival of a veritable heaven on Earth through market expansion and deregulation.
“By providing immediate feedback to policymakers, the capital markets have increased the benefits of following good policies and increased the cost of following bad ones,” he and a co-author wrote. Good policies result in “higher financial asset prices. Investors are supportive. Bad policies lead to bad financial market performance, which increases investor pressure on policymakers to amend their policy choices.”
The result: “The quality of economic policymaking has improved over the past two decades, which has helped improve economic performance and macroeconomic stability.”
Given the central role such thinking played in the financial crisis, it’s a wonder that Romney can support it and poll at more than 15 percent. Where did such fantasy-based policies come from, and why are they so alluring?
Don’t blame Adam Smith. His concept of the invisible hand, which conjures beneficial outcomes from peoples’ greedy ends, was really meant only as a metaphor. He recognized the need for constraints. As he put it in “The Wealth of Nations”: “Those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments.”
Smith’s invisible hand grew into a distinct philosophy starting in the 1950s, when mathematical economists built theories around that idea and made claims about the supposedly “optimal” properties of markets. The rhetoric surrounding this work, with its welfare theorems and proofs of optimality, is far too abstract to tell us anything about real markets or economies, as honest economists admit. As Yale’s Robert Solow put it a couple years ago, anyone “faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.”
Another argument for the infallibility of markets goes back to that titan of American economics, Milton Friedman, who argued that they effectively pool the information of the many, acting to harness the famous wisdom of crowds. Get enough people weighing in with their own views on the value of a company or an economic policy -- actively investing or pulling back in response -- and any flaws will cancel out, leaving the crowd’s assessment wise.
Sounds too good to be true, and indeed it is. In his 2004 book “The Wisdom of Crowds,” James Surowiecki was careful to note that that the effect only works if people aren’t biased or systematically disposed to making poor judgments. It also only works if people act independently, without being influenced by gossip or the opinions of others. Let these real-world factors enter, and the wisdom often turns into something very different.
In some clever experiments, mathematician Jan Lorenz and others from the Swiss technology university ETH Zurich tested how ordinary human interactions affect the wisdom of crowds. They had volunteers answer questions -- such as “How many murders were there in Switzerland in 2006?” -- for which the true answers were known. In some trials, the participants knew what others chose (in detail, or on average) before making their own choice.
As it turns out, the crowd really isn’t so wise, even when people do act on their own. The average response on the murders question, with no social influence, was 838, compared with a true number of 198. The error reflects a known bias: When people try to estimate numbers for things they know little about, they often tend to guess for the right scale or magnitude. Is it roughly 10, 100 or 1,000? That’s a useful thing for individuals to do, but it doesn’t make a crowd wiser.
When given access to others’ estimates, the participants did even worse. They tended to revise their own guesses to fit more closely with those of others, a dynamic that pushed the average answer toward the periphery of the range of estimates. This is doubly discouraging, because the narrowing range of individual opinions makes the group appear more certain of its answer. In short, we have a recipe for stupidity.
The illusory certainty of the crowd also gets transferred to individuals. Interviews after the experiments found that social influence, while it didn’t make the crowd’s estimate any more accurate, did fill the participants with a strong belief in the group’s infallibility. Rather than the “wisdom of crowds,” we have the “unwarranted confidence of crowds.” I can’t help but relate this to some of the biggest blunders of recent years, such as the belief that Iraq had weapons of mass destruction and the expectation that house prices would only go up. (There’s some further discussion of these experiments on my blog.)
Now let’s think again about whether markets know best about anything. It’s hard to imagine a more socially influenced environment than modern finance, with rumors flying through the business press and corporate boardrooms, fund managers herding like cattle to fashionable investments, financial analysts mostly making the same predictions as other financial analysts. We have a host of reasons to expect very little wisdom in the verdict of the crowd as expressed in the market.
Whoever wins the presidential election, the market will react. If we have to give it a personal spirit, it will “render its verdict.” It won’t be inherently wise or anything else. Up, down, left, right or inside out, the result won’t tell us much about the wisdom of current policies. It’s just the market, not a miraculous machine for good governance.
(Mark Buchanan, a theoretical physicist and the author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,” is a Bloomberg View columnist. The opinions expressed are his own.)
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