Here’s an insightful article by Mark Sunshine in which he identifies the assumption of fair, free and open markets as a reason that economists blew it. I have less trust than him in the notion that people act rationally and would add the "people act rationally" belief to the flaws of models. A must-read article to read along with this one is Ryan Grim’s Priceless: How The Federal Reserve Bought The Economics Profession. "Priceless" explains why not only are the markets not free, fair and open, but neither is the economic profession. – Ilene
How Did Economists Blow It? Part 3 – The Assumed Markets Theory
Courtesy of Mark Sunshine’s The Sunshine Report
Two weekends ago Paul Krugman explained in a New York Times Magazine article that many economists can’t forecast the economy because they have a cultish belief in the nearly always wrong efficient market theory. Mr. Krugman’s solution, an academic exorcism where economists renounce their loyalty to the efficient market theory and swear allegiance to neo-Keynesianism, has created quite a stir in the profession and prompted a number of personal and professional attacks on Mr. Krugman. Unfortunately, both Mr. Krugman and the efficient markets believers are both wrong. The theory is correct but the conditions necessary for the efficient markets theory to work don’t exist.
Mr. Krugman suggests that economists missed the Great Recession because they relied upon mathematical models that assume the economy is a series of free and efficient markets and therefore a self correcting predictable economic organism. Mr. Krugman proposes “economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly”. Instead, Mr. Krugman’s solution is to substitute Keynesian models for efficient markets models when he states that “Keynesian economics remains the best framework we have for making sense of recessions and depressions”.
Unfortunately, the usually smart and intuitive Mr. Krugman forgot that for the efficient market theory to work its primary assumption must be true; that the markets are free, fair and open, and that is simply not the case.
Mr. Krugman isn’t alone in assuming and forecasting based upon markets that don’t exist, and then not understanding why forecasting don’t work. Pretty much the entire economics profession plays a game of pretend when they write about markets without checking the most basic real world underlying operational and functional assumptions.
Economists assume that the U.S. markets are free, fair and open and therefore a perfect Petrie dish for testing free market theories. But, instead of trying to figure out if free, fair and open markets exist, when their mathematical models don’t work many prominent economists (including Mr. Krugman) take the position that investors aren’t rational, society has a herd mentality and generally we are all “idiots”. These economists pontificate without self doubt and publish without reflection.
I disagree with the “our models are wrong because people are idiots” crowd and think that, as a group, society is extraordinarily smart, logical and rational. When we act in a herd it is because we are all getting stuck by the same cattle prod and being bit at by the same sheepdog. Instead of saying people are dumb and friction exists in markets, economists should spend their time trying to understand the common sociological, governmental, psychological and economic stimuli that motivate each and every one of us.
I can’t think of a single major “market” that always satisfies the underlying assumptions of the efficient market theory. Even the New York Stock Exchange, perhaps the most free and open market in the world, sometimes is a free, fair and open market and sometimes isn’t. Free, fair and open are moving targets that require constant vigilance to make sure societal drift doesn’t convert markets into rigged exchanges. When the large brokerage houses are able to rip billions of dollars of profit out of New York Stock Exchange trades by front running their clients with really fast computers, the New York Stock Exchange fails to be free, fair and open. When no one is really sure what the short sale rules are or how they work, and neither does the SEC, the market stops being fair. And, when some people have inside information that they sell to their best clients, the New York Stock Exchange stops being the showcase for the efficient market theory and turns into a Middle Eastern rug bazaar.
But the problems don’t stop with the NYSE. Free market advocates argue that the credit derivatives markets provide asset price discovery and increase efficiency but never test the underlying assumption of whether or not these markets are real. For example, it’s unclear if prices reported on credit default swaps (which are unregulated) are actually accurate or made up and most insiders say that it is well known reported prices are often fake. Even more uncertain is whether or not prices in the credit default swap market, if reported accurately, are being manipulated by ad hoc cartels that are executing coordinated and cooperating trading strategies.
Even LIBOR, the floating interest rate index that underpins most corporate and personal debt in the world, isn’t really a market rate. It is an estimate of a market rate that is calculated by an industry trade association in secret, without oversight and based upon inputs from a select group of industry sources. The supposedly free and fair interbank markets that last year were the focus of intense media and public policy scrutiny don’t trade based upon actual published information and are therefore neither fair nor open. Once again, the requirements for the efficient market theory to be valuable in predicting behavior haven’t been met.
Free market theories require equal bargaining power among market participants. Who believes that consumers have equal bargaining power against banks, insurance companies or utilities? Or, that consumers have real choice when they execute the simplest financial transactions such as accessing revolving consumer credit? The choice of “MasterCard” or “Visa” isn’t real choice or competition. And, when was the last time any consumer was granted credit after opting out of the credit bureau system? Most consumer credit contracts are contracts of adhesion, i.e., consumers don’t have a real choice or bargaining power, and, as a result, the underlying assumptions for efficient markets don’t exist.
Economists who fell in love with free market theories can’t stand the fact that rules are needed to make sure that markets are free, fair and open. After all, rules are typically enforced by governments and are called regulations. Government regulation is the sworn blood enemy of true free market believers. Free market believers forgot that regulation is supposed to promote competition and instead got carried away and destroyed market regulation that that made sure that the playing field was level and fair.
Virtually all economists would rather shift the blame for missing the Great Recession onto someone else. Free market economists try to explain their mistakes by saying that that markets are irrational and it isn’t their fault for not being able to understand and predict irrational and random behavior. Some economists, like Mr. Krugman, shift the blame to other economists for not realizing that while market theories have a place in economics, they are inferior to Mr. Krugman’s favorite Keynesian framework. 
But mostly economists got it wrong because they didn’t watch old episodes of All In The Family. If they simply watched late night TV economists wouldn’t have assumed anything about markets because they would have known what Archie Bunker explained to America more than 30 years ago:
“When you assume you make and ass of you and me”.
