Deprogramming the cult of the Efficient Market

Another great EconTalk podcast, this time a discussion with Alan Meltzer of CMU, a leading expert on monetary policy and the history of the Federal Reserve, and a confidante of officials like Alan Greenspan.

At about minute 45 of the podcast we are treated to a revealing 10 minute dialog between Meltzer, a member of the cult of Efficient Markets (EM), and recovering cult member Russ Roberts (host of EconTalk and GMU econ professor), who is starting to realize that reality diverges from the teachings of the cult. Meltzer's thesis is that reckless behavior by bank executives was largely driven by expectations that they would be bailed out in case of disaster. He claims this crisis was caused by moral hazard and the banksters knew full well the risks they were taking. (And the pension funds and sovereign wealth funds that also bought the toxic stuff? Were they expecting a bailout too?) Russ wonders whether top executives really understood the structured finance of mortgages, perhaps neglected fat tail events, perhaps were irrationally overconfident. Roberts' points sound very "behavioral" and not at all EM.

Meltzer cannot bear to admit that the market is not all-knowing. Throughout most of the podcast he steadfastly maintains that current share prices of banks give an implicit (and more accurate than any other) valuation of the complex mortgage securities on their books. This is about as nutty as the thinking that got us into the crisis in the first place! The markets have been valuing CDO tranches from the beginning; why did they get it so wrong for so long? Now people trading bank equity have got it right? (How many are just gambling on probabilities of different rescue / nationalization outcomes?) Meltzer even mentions that the Fed rescue of LTCM was a source of moral hazard, neglecting the fact that the investors and principals were completely wiped out in the rescue.

Russ has made great progress in his thinking during the last few years of doing EconTalk interviews. It's a tribute to his intellectual honesty and common sense that he can, at this advanced age, overcome the conditioning he received from his education within the Chicago EM cult. Most cult members are more like Meltzer. He cannot abandon the faith, even in the face of a market failure of these historical proportions.

But of course it is Meltzer I see on national TV, holding forth with utter certainty on the crisis. For some reason it is he, not Russ, who gets to make expert predictions.