This post is by Mark Dow
Very few things rouse the rabble as much as an ideological debate. And over the past year it has been looking like we are having the beginnings of a nasty one in economics and finance. The current economic and financial crisis has shaken a few trees and made many go back and question first principles. Often, the answer is that the prevailing received economic and financial wisdom has fallen woefully short.
That said, those who are looking for a debate here may be disappointed. A narrow ideological debate is not the can I wanted to open up. Instead, I thought it would be useful to review from an historical perspective how we got here, and then address why this should matter.
For me, making the transition from economist to trader raised a lot of issues about efficient markets and animal spirits. It underscored the shortcomings of formal training and our incomplete understanding of the human element in finance and economics. As a result, the issue of paradigm shift has been simmering on my backburner for quite some time now.
One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing, as if they were a pendulum, from one local extreme to the opposite. In other words, around any given trend there are oscillations above and below, moments of high bullishness and high bearishness. Time and time again we transition from moments when any positive statement is met with skepticism to moments when no one dares say anything negative. In short, we slowly change directions, see that the new direction starts to work and jump on, take the new direction too far so that it stops working, and then we start the whole process all over again.
These pendular swings in the market can take anywhere from a couple of weeks to numerous months, and they are marked by a distinct, three part psychological process: denial, migration, capitulation. In the first phase, participants deny that a change in market character is truly afoot. Markets rally on bad news (or sell off on good news) and traders look for others to blame for their trading losses (suggestion: when in doubt blame government; no one will ever disagree.) Then, little by little, traders begin to recognize ‘what is working’, start to question their previous beliefs, and then begin migrating from their old camp to the new. In the last phase, capitulation (or give-up phase), the final holdouts switch camps and jump on the new bandwagon—often in climatic fashion. This then completes the pendular swing.
This manifestation of human nature is not confined to intermediate term swings in the market. It also applies to ideological fashions in economics. At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.
Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.
As a result of the belief that Keynesian policies ‘worked’, its adherents grew in number. The 50s and 60s were characterized by less faith in markets and more faith in government’s ability to solve problems. One might call this the ‘migration’ phase. By the time the 70s rolled around things had been taken even further, and we began to see wage/price rigidities and activist monetary and exchange rate policy take a serious toll. You could say people took a good thing too far.
The onset of the Reagan era marked the end of this pendular swing. Policies that placed greater faith in markets and considerably less in government, coupled with a more independent central bank, were perceived to have saved the economy from Keynesian excesses. As the economy grew over the course of the 80s, this new ideology—monetarist, supply-side, efficient market hypothesis—saw many new adherents jump on the bandwagon. By the late 90s/early 2000s, this prevailing ideology was scarcely seriously challenged. Markets were believed to be largely infallible and self-regulating, and no one doubted that everything government touched was going to be ruined. Fast forward to 2008: markets did fail, and the pillars of the existing ideological edifice started to crack. You could say people took a good thing too far.
Thus, the pendulum has started to swing again. Why does this matter? In short, we are going to be facing a lot of policy issues in the coming years, and many in markets, policy circles, and in the population at large are having a hard time getting off the paradigm. A lot of the baby boomers who learned their economics reading the Wall Street Journal editorial page in their formative years are still stuck in 1982. The high degree of residual ideology in the system is impeding, in my view, the fundamental rethink that the US needs at this juncture to get ahead and stay ahead of the rapidly moving global curve. In other words, with so many people still looking in the rearview mirror it increases the chances of car wrecks.
In my experience there is little room for ideology in economics. No set of rules or principles can fit all of reality for all points in time. The world to too complex and moves too quickly for this. The ‘perfect’ mix of markets and government is not a static concept. It is dynamic, and highly contextual. Again this post is not ideological. It is more a cautionary tale about human nature and the way we follow trends. We are trendy by nature. We stick with our old ideas for too long after the facts on the ground change. We then begrudgingly migrate to what appears to work, and, inevitably, take things too far. No amount of regulation can fix this; it can only mitigate the consequences from it. Let’s just hope that the amplitude of the next pendular swing is less extreme—but I suspect we are years, if not decades, away from worrying about it.