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Meagre rations

It might seem a brave question to ask as the world licks its wounds from the economic apocalypse of the last 12 months, but economists are still arguing as to whether markets are rational.

The growth of behavioural economic thought through the last 10 years had already started the catfight. The credit crunch, which the IMF now estimates to have cost the world $10 trillion and sent government debt soaring to nearly 240% of GDP in Japan, 112% in the US and 99% in Britain, should have provided the answer.
credit crunch carton cartoon

But there are still those who believe that markets are universally rational because the irrationality of the majority can be corrected by the actions of the few who lead and study closest – the expert traders. These few, it is said, make profit of the foolish, take their money and turn it into their own success and thereby smooth out the irrationality of markets.

Tell that to Lehman Brothers.

Bernie Madoff certainly took advantage of the inexpert, or the overenthusiastic, but who profited?

How can markets not be irrational, they are a human phenomenon. Between 1928 and 2000 the US stock market rose at about 10% per year. Over the same period the Friday closing to Monday close three-day prices were always negative. Is that rational?

bank sale cartoonThe 2008/9 problem is the same one that withered the Dutch tulip investors, burst the South Sea Bubble buyers, and sank the Darien enthusiasts: the failing of allowing emotion, like fear or greed, rule head.

Only an idiot would suggest that a human being is universally rational in his actions. In fact the greatest economist of them all Adam Smith wrote in The Wealth of Nations of the "overweening conceit which the greater part of men have of their abilities" in other words what today economists call overconfidence.

Those who have made money in the time of economic collapse, like George Soros or the Sage of Omaha, have succeeded in combining rational analysis with irrational opportunity. They understand the past to get a picture of the present and an inkling of the future.