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Theories of rational behaviour are facing crisis

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By Tony Jackson

Published: March 23 2009 02:00 | Last updated: March 23 2009 02:00

The general economic crisis has spawned various sub-crises in banking, governance and so forth. But there is another grumbling below the surface: a crisis of financial theory.

Consider three stories in this paper last week. First, the US authorities are to allow banks more freedom in valuing their financial assets.

Second, Shell is to spend an extra $5bn-$6bn on plugging its pension deficit.

Third, ex-General Electric boss Jack Welch has recanted on the gospel of shareholder value, now describing it – in the short run, at any rate – as “a dumb idea”.

All three stories can be referred back the same root: the idea that the market price of a share or other security is somehow true, or at any rate truer than any other price that can be arrived at.

That in turn rests on a notion embedded in financial theory for the past half-century, that of rational expectations. Markets embody the balance of considered, informed opinion on likely outcomes. Individuals may be too bullish or bearish, but the market is neither. The two cancel out.

A moment’s reflection tells us this is nonsense. Take one simple example, that of Dutch prime residential mortgage-backed securities.

These are now selling – if you can find a buyer – at some 50 cents on the euro. This apparently implies that 75 per cent of mortgage holders will default, and that their homes will only fetch 25 per cent of the mortgage value. Given that Holland missed the housing bubble of recent years, no one actually believes that.

But professional investors were burnt on the way down and are not about to bet their jobs on this being the bottom. That fear may not be irrational, exactly, but it is a long way from a considered opinion.

That brings us back to last week’s guidance from the US Financial Accounting Standards Board on when securities must be marked to market. In essence, if there is no active market and there is evidence of distressed selling, the security can be marked to model instead.

The asymmetry of this bears thinking about. In the dotcom boom, there was plenty of distressed buying of bubble stocks. As with those Dutch mortgage securities, investors did not for a moment believe market valuations. But their jobs were at stake in the same way.

The difference is, of course, that in an irrational bull market there is any amount of turnover, while in an irrational bear market there is none. So it is quite in order to book profits when a stock goes from $10 to $100, but not losses when – as with some dotcom stocks – it then collapses to $1.

The illogic is taken further when we compare the Shell example. Some banks at present may in fact be insolvent. If the worst comes to the worst, their assets will be sold at the market price, fair or not.

But Shell is nowhere near insolvent and its pension fund has decades to play with. The deficit figure may be interesting information for investors. Why it should require the diversion of much-needed cash flow right now is a different question.

So to Mr Welch. Shareholder value – or value-based management, or total shareholder return, or whatever – became popular in the 1980s.

As a theory, it was custom-built for a bull market. Management success – and rewards – were measured by totting up capital gains and dividends. In other words, it mainly came down to the stock price.

The doctrine of rational expectations, of course, said that if a company’s stock price fell, that could only be because its prospects had worsened. The logical inference – that in a sustained bear market all managers must be dummies together – was not addressed.

Again, this illogic can be taken a stage further. If the job of managers was to raise the share price, their objectives were those of shareholders. But although shareholders obviously knew a lot less about the company, they were still urged to wield greater influence.

Now, it seems, that is no longer the job of managers. So shareholders, whose objectives are unchanged, know even less about what managers are supposed to be doing. Yet they are urged by various parties – including governments – to address the crisis by exerting yet more influence. Go figure.

My conclusion from all this is one I have expressed in this column before: that it is better not to know something than to know something that ain’t so.

In the bull market years, it became axiomatic that share prices conveyed unique and objective information. That notion, it now appears, was a mere feel-good confirmation of what was happening anyway.

Behind all that was a group of theories about rational behaviour, which are now blown to the winds. What will replace them is unclear, but we are better off without them.

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