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Beyond Mechanical Markets

Book Description

In the wake of the global financial crisis that began in 2007, faith in the rationality of markets has lost ground to a new faith in their irrationality. The problem, Roman Frydman and Michael Goldberg argue, is that both the rational and behavioral theories of the market rest on the same fatal assumption--that markets act mechanically and economic change is fully predictable. In Beyond Mechanical Markets, Frydman and Goldberg show how the failure to abandon this assumption hinders our understanding of how markets work, why price swings help allocate capital to worthy companies, and what role government can and can't play.

The financial crisis, Frydman and Goldberg argue, was made more likely, if not inevitable, by contemporary economic theory, yet its core tenets remain unchanged today. In response, the authors show how imperfect knowledge economics, an approach they pioneered, provides a better understanding of markets and the financial crisis. Frydman and Goldberg deliver a withering critique of the widely accepted view that the boom in equity prices that ended in 2007 was a bubble fueled by herd psychology. They argue, instead, that price swings are driven by individuals' ever-imperfect interpretations of the significance of economic fundamentals for future prices and risk. Because swings are at the heart of a dynamic economy, reforms should aim only to curb their excesses.

Showing why we are being dangerously led astray by thinking of markets as predictably rational or irrational, Beyond Mechanical Markets presents a powerful challenge to conventional economic wisdom that we can't afford to ignore.

Table of Contents

  1. Cover Page
  2. Title Page
  3. Copyright Page
  4. Table of Contents
  5. Acknowledgmentss
  6. What Went Wrong and What We Can Do about It
    1. The Fatal Flaw
    2. Assuming Away What Matters Most
    3. The Imperfect Knowledge Alternative
    4. Fishermen and Financial Markets
    5. The Survival of the Rational Market Myth
    6. Opening Economics and Finance to Nonroutine Change and Imperfect Knowledge
    7. Imperfect Knowledge Economics and Its Implications
    8. A New Understanding of Asset-Price Swings, Risk, and the Role of the State
  7. Part I - The Critique
    1. 1. The Invention of Mechanical Markets
      1. Economists' Rationality or Markets?
      2. Was Milton Friedman Really Unconcerned about Assumptions?
      3. The Post-Crisis Life of Interacting Robots
      4. Missing the Point in the Economists' Debate
      5. The Distorted Language of Economic Discourse
    2. 2. The Folly of Fully Predetermined History
      1. The Fatal Conceit Revisited
      2. The Pretense of Exact Knowledge
      3. The Economist as Engineer
      4. Staying the Course in the Face of Reason
    3. 3. The Orwellian World of “Rational Expectations”
      1. Muth's Warning Ignored
      2. The Rational Expectations Revolution: Model Consistency as a Standard of Rationality
      3. The Spurious Narrative of Rational Expectations
      4. A World of Stasis and Thought Uniformity
      5. Economists' Rationality and Socialist Planning
    4. 4. The Figment of the “Rational Market”
      1. Pseudo-Diversity in the “Rational Market”
      2. The Irrelevance of the “Rational Market”
      3. Beware of Rational Expectations Models
      4. The Fatal Conceit of the Rational Expectations Hypothesis
    5. 5. Castles in the Air: The Efficient Market Hypothesis
      1. The Market Metaphor
      2. Imagining Markets in a Fully Predetermined World
      3. Samuelson's Doubts
      4. The Illusory Stability of the “Rational Market”
      5. Efficient Market Hypothesis and Asset-Price Swings
    6. 6. The Fable of Price Swings as Bubbles
      1. Reinventing Irrationality
      2. Bubbles in a World of Rational Expectations: Mechanizing Crowd Psychology
      3. A Seductive Narrative of Behavioral Bubbles
      4. Limits to Arbitrage: An Artifact of Mechanistic Theory
      5. The Trouble with Behavioral Bubbles
      6. Forgotten Fundamentals
  8. Part II - An Alternative
    1. 7. Keynes and Fundamentals
      1. Was Keynes a Behavioral Economist?
      2. Imperfect Knowledge and Fundamentals
      3. Are Fundamentals Really Irrelevant in the Beauty Contest?
      4. Fundamentals and Equity-Price Movements: Evidence from Bloomberg's Market Stories
    2. 8. Speculation and the Allocative Performance of Financial Markets
      1. Short-Term and Value Speculators
      2. How Short-Term Speculation Facilitates Value Speculation
      3. Speculation and Economic Dynamism
    3. 9. Fundamentals and Psychology in Price Swings
      1. Bulls, Bears, and Individual Forecasting
      2. Persistent Trends in Fundamentals
      3. Guardedly Moderate Revisions
      4. Price Swings in Individual Stocks and the Market
      5. Price Swings, Genuine Diversity, and Rationality
      6. Sustained Reversals
    4. 10. Bounded Instability: Linking Risk and Asset-Price Swings
      1. The Indispensable Role of Asset-Price Swings in Allocating Capital
      2. Historical Benchmarks as Gauges of Longer-Term Prospects
      3. The Unfolding of Excessive Price Swings
      4. Linking Risk to Distance from Benchmark Levels
      5. How Markets Ultimately Self-Correct
      6. The Return of Fundamentals
    5. 11. Contingency and Markets
      1. Contingent Market Hypothesis
      2. Contingency and Instability of Economic Structures
      3. The Fleeting Profitability of Mechanical Trading Rules
      4. Temporary Profit Opportunities
      5. An Intermediate View of Markets and a New Framework for Prudential Policy
    6. 12. Restoring the Market-State Balance
      1. The Importance of Policy Reform for Financial Markets
      2. Rationale for Active State Intervention in Financial Markets
      3. Excess-Dampening Measures and Guidance Ranges
      4. Active Excess-Dampening Measures
      5. Excessive Price Swings and the Banking System
      6. Imperfect Knowledge and Credit Ratings
  9. Epilogue
    1. What Can Economists Know?
    2. The Search for Omniscience
    3. Sharp Versus Contingent Predictions
    4. Recognizing Our Own Imperfect Knowledge
    5. Imperfect Knowledge Economics as the Boundary of Macroeconomic Theory
  10. References
  11. Index