As an engineering student in the mid-1980s, I was required to take at least one social science type elective course. My Professors argued that I should take an economics course as every engineering student needed to have a basic understanding of the social science called economics. I followed this sage advice and I must admit I thoroughly enjoyed the macroeconomcs portion of the course by far the most. Later in the 1990’s when I took my MBA degree I again found myself enjoying macroeconomics as the course material steered me deeper into the thinking of people like Keynes and Milton Friedman.

Sadly today we find ourselves at a dark crossroads with only a tattered and worn roadmap to guide us forward. Macroeconomics has been seriously discredited. Nobel Prize laureate and leading economics thinker Paul Krugman says ” the past 30 years of macroeconomics has been spectacularly useless at best and positively harmful at worst”. A stinging criticism if ever there was one.

The history of macroeconomics starts in the mid-1930s when economist John Maynard Keynes challenged the then widely held belief that full employment in an economy will always prevail. What people earn, they either spend or invest. Nothing gets left behind according to the classical beliefs. Keynes advanced the idea that investment was governed by “animal spirits” within entrpreneurs as they faced an uncertain outcome of their ventures. Likewise, this same uncertainty drove individuals to hoard some of their money as liquid cash rather than invest it. This so called “liquidity preference theory” eventually came to hold sway over the financial markets and interest rates. Keynes published his ideas in 1936 in the “General Theory of Employment, Interest & Money”. If the “animal spririts” surged and people hoarded money, he argued, the economy would falter and unemployment would rise. Keynes argued that the Government should bear a responsibility to manage the demand in an economy by cutting interest rates and spending taxpayer dollars on stimulative public works projects that would create jobs.

This mode of thinking was largely adhered to right up until the 1970s when the North American economy experienced for the first time something called “stagflation” – a lethal combination of inflation and stagnant growth. This stagflation conundrum led to a split of the macroeconomcs academic field into two camps -the purists and the pragmatists. The purists argued that Central Bankers should refrain from meddlesome policies because the economy over time will always right itself. The pragmatists argued that policymakers should by all means meddle in an effort to revive the economy. The high inflation and stagnant growth that marked the 1970’s eventually did correct itself after Paul Volcker at the Federal Reserve raised interest rates dramatically high in a successful attempt to wring the neck of inflation. As the 1980s got underway, pursists and pragmatists reached a middle of the road concensus on matters relating to macroeconomics and a period of quiessence ensued.

In the early 1970s, economists began giving thought to asset prices. Eugene Fama at the University of Chicago began exploring a theory that said the price of an asset always reflects the amount of available information in the public domain that is relevant to its price. In 1978 economist Michael Jensen took the matter one step further and boldly announced that there was no other theory with more solid empirical evidence supporting it than the Efficient Market Hypothesis (EMH). From the EMH it then followed that any price deviations in a financial asset would not last for long and that bubbles could not form.

Wall Street embraced the EMH and went on to structure the profession of financial engineering around these notions. Derivatives ranging from simple futures and options to the infinitely more complicated credit default swaps and collateralized debt obligations soon became the norm on Wall Street. People entering the brokerage profession were beaten over the head with the notion of the EMH. The much coveted CFA designation also embraced the EMH with open arms. As a CFA candidate in 2004, it simply got to the point where I could no longer stomach the nonsense being touted in the CFA texts. In Canada, even the Canadian Securities Course – which every Investment Advisor must take – was firmly in the EMH camp. Politicians too embraced EMH. The Reagan, Bush and Clinton administrations embraced the EMH notion and made big strides to allow the markets to regulate themselves. Looking back, we now call this “laissez faire” economics. This mode of thinking contributed to the behavior of Alan Greenspan at the Federal Reserve who not so subtly structured his policy around asset valuations in the market place. Laissez faire economic thinking culminated in an aggressive move that saw passing of the Gramm Beach Bliley Act in 1999. This Act effectively dismantled the Glass Steagall Act of 1933. With this repeal, banks could now own other financial companies.

As we all have now painfully realized, a deregulated financial industry is not necessarily capable of acting un-supervised. The past number of years have also underscored the weakness of the Efficient Market Hypothesis (EMH).

The Long Term Capital Management (LTCM) fiasco of 1998 that saw a group of Ph.D. experts make and subsequently lose massive sums of money in itself was a stunningly clear cut example that the Efficient Market Hypothesis does not work.

When the Nasdaq was at the 1150 level in 1997, that price level (in theory anyhow) was an unbiased reflection of all information including the risk.

In 2000 when the Nasdaq surged to over 5000, are we then to believe that this price level too was an unbiased reflection of the risk involved and a reflection of fair value? In 2003 when the Nasdaq had crashed back to the 1150 level, are we to believe that this price level was a reflection of the risk ? Try explaining this to the individual investors that lost heavily in high-tech and dot-com stocks that their financial advisors had told them to buy.

Are we to believe that those sliced and diced tranches of collateralized debt that Moody’s and Fitch gave AAA ratings to were fairly priced? Are we to believe that those savvy investors who made huge sums of wealth from the collapse of sub-prime mortgages did so purely by accident?

As we now sit at a dark and dusty crossroads, the financial industry is admitting it is somewhat lost and is thus willing to look at new ideas to get itself back on track. On a recent flight from Toronto, I took the time to read a new book – The Origin of Financial Crises – by George Cooper (2008).

George Cooper is a former investment banker who today makes his home in London, England. To find this book, call the folks at Books for Business on Adelaide Street in Toronto at (416) 362-7822 or go to their website at http://www.booksforbusiness.com

Mr. Cooper does an eloquent job of tackling the whole Efficient Market Hypothesis head on, no punches spared. He then goes on to present in an equally eloquent fashion the thinking of one Hyman Minsky, an economist who receives far too little recognition in our “efficient” world.

Minsky is noted for his Financial Instability Hypothesis. Where the Efficient Market Hypothesis argues that markets will strive towards a state of equilibrium being influenced along the way by external stressors, Minsky’s theory of Instability argues that financial markets can generate their own internal stressors that cause waves of credit expansion and asset inflation followed by waves of credit contraction and asset deflation.

Mr. Cooper then goes on to weave into the fabric of this book a critical examination of Central Banks and their flawed policies. As he points out, if markets are so efficient, then why do we even need Ben Bernanke and the FOMC to set key interest rates? Why not just let the market forces take care of that task ?

Sadly, today we have what Mr. Cooper calls an assymetric governance system. During economic expansions, responses from the Fed are slow and delayed, but during economic contractions the response is swift and sure. Think about recent events and you are sure to agree. Alan Greenspan could have easily slowed the housing bubble, but no – he took a hands-off, “laissez faire” approach. Now that crisis is upon us, the Fed is throwing money out of helicopters… or so it seems.

Mr. Cooper concludes that we should scrap the Efficient Market Hypothesis and embrace the leanings of Minsky and his Instability Hypothesis.

Behavioural Economics is another school of thought now gaining credibility. This notion posits that human beings tend to be too confident of their own abilities and tend to extrapolate trends into the future. This is the stuff bubbles are made of. Ask yourself, how many times you have  heard a friend or neighbor brag about how much his house has risen in value since he bought it and how high he thinks it will go. Behavioral economics also asserts that as market prices correct, people can act irrationally and sell in a panic thus exagerating the depths of the sell-off. One of the most noted proponents of behavioral economics is Robert Shiller of Yale University. He is most noted for the Case Shiller Housing Index which accurately forsaw the coming housing debacle.

Lastly, a school of thought that is trying to gain momentum under the guidance of M.I.T. Professor Andrew Lo is that of the “Adaptive Market Hypothsis”. Dr. Lo argures that humans work by trial and error. If one investment strategy does not work , they try another. Thus old strategies become obsolete and new ones are called for. Dr. Lo is calling for an independent investigative board to examine all financial failures, much like the NTSB investigates all civilian airline accidents.

The case is exceedingly clear. Macroeconomics has entered a dark period and must be redefined and reinvented. The concept of risk needs to be re-examined. The role of Central Bankers needs to be looked at with a

sceptical eye. The idea of bubbles has to be critically reviewed. Economics professors must come out of their dark office corners and walk down the hall to embrace Finance professors. New theories to explain how and why liquidity can suddenly sieze up must be set forth.

As we begin to do these things, the way forward from the current dark crossroads will become clearer and new light will be cast upon macroeconomics as a social science.

By Malcolm Bucholtz B.Sc, MBA
Investing Success