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Tuesday, October 15, 2013

Human Weakness Enables Market Bubbles: A Nietzschean Perspective

As a young idealist in business school, I believed in the efficient market hypothesis; an efficient market based on perfect competition would obviate excess profits (e.g., monopoly rents) while keeping prices as low as possible. I assisted a professor with his article on the NASD (National Association of Securities Dealers) as a stellar example of industry self-regulation. The ideology cutting off the far left of my peripheral vision, I dismissed the possibility that an industry would look the other way on a miscreant firm as executives of other companies fear accountability from the industry association. Moreover, the business practitioners may profit, at least in the short term, from foisting on the general public the illusion of industry self-regulation, which can serve as a front protecting a squalid underbelly.
Fast-forward to 2013, to the Nobel Prize in economic science (a science?). Fama, Hansen, and Shiller shared the award for their respective work on the efficient market hypothesis. Specifically, they demonstrated theoretically how markets can be inefficient in the short term but highly accurate in the long term in pricing assets such as stocks and houses. The high tech bubble in the 1990s and the housing bubble in the 2000s were therefore not aberrations. By implication, government regulation oriented to forestalling bubbles received a sense of vindication while the free-market hypothesis applied to asset-pricing over the long term was left standing. 

 The proportion of sub-prime (borrowers ordinarily not qualifying) mortgages clearly leaped during the worst years of the housing bubble. Was this a case of many people over-reaching?
“The free-market people have a point that the markets are efficient in the long term. That hasn’t been thrown out the window. What has been thrown out the window is the idea that the market is always efficient in the short term,” Nariman Behravesh, chief economist at IHS, provides as a summary. He points to “a strong herd effect in financial markets” to explain the hole in the efficient market hypothesis.[1]
Nietzsche uses the term “herd animals” to characterize the weak, whose sickness and related resentment of the strong makes natural a “pathos of distance” between the weak and the strong. The latter relish their self-confident strength, and thus have no reason to over-reach. Interestingly, the “dot.com” and housing bubbles both involved over-reaching, whether by entrepreneurs who presumed they were stronger than they actually were or home-buyers whose eyes were bigger than their stomachs. In other words, the “strong herd effect” is not simply following others as if humans were fish swimming in schools; the phenomenon involves the over-reaching instinct that can be found in human weakness.
For example, on the very day of the Nobel Prize announcement, the Pentagon’s inspector general released a report claiming that Boeing had charged the U.S. Army for new helicopter parts even as employees installed used parts instead. The “switch” had allegedly occurred four times over the previous five years. According to the report,” Boeing significantly overstated estimates” of new components needed for CH-47F Chinook helicopters and “primarily installed used parts instead” under a $4.4 billion contract awarded in 2008.[2]
That fraud can easily compromise the efficiency of a market in the short and even medium term is hardly surprising; that the presumptuousness of weakness as a sort of “brain sickness” is also in the mix might be. The managers at Boeing who swapped the parts presumed that the company (and the managers themselves) was strong enough to get away with short-changing the U.S. Army. Put another way, that the managers viewed the trick as necessary implies that they viewed the company as being in a weak condition, perhaps from over-reaching. Just in being oriented to such games and over-reaching in the process, the managers can be said to have been weak. Here, being a herd animal refers to sporting a small-mindedness rather than following one’s group. Therefore, we can enlarge the “strong herd-effect” to include Nietzsche’s notion of the “herd animal.” The hole in the efficient market hypothesis is consequently deeper than even the Nobel winners assume in their respective writings; a serious “brain sickness” possible in human nature (where it is weak or has been weakened) legitimates government (not “self”) regulation oriented to obviating the susceptibility of asset-pricing markets to bubbles and other inefficiencies. Markets, it turns out, are human, all too human, after all.

[1]Tim Mullaney and Mike Snider, “Americans Win Economics Nobel,” USA Today, October 15, 2013.
[2] Tony Capaccio, “Boeing’s Pentagon Charges Questioned in Audits Four Times,” Bloomberg News, October 14, 2013.