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The Financial Crisis As The Final Event Of The 20th Century

I've been holding off weighing in on Justin Fox's fitting new book, The Myth of the Rational Market--a kind of intellectual history of the idea that markets know best--mostly because I haven't had a chance to read it yet and didn't want to go off half-cocked. I still intend to do that and report back. But, in the meantime, Fox has helpfully summarized his argument in an extended version of his Time column this week, and it's well worth your time.

One of the most interesting ideas in the column (and, presumably, the book) is the idea that the efficient market hypothesis took hold not just for ideological reasons (or, worse, greed), but because it reflected a genuine faith in scientific progress. As Fox tells it: 

A key figure in the revival was the University of Chicago's Milton Friedman--and his libertarian ideological bent was certainly a factor. ... But Friedman was a scientist too. During World War II, he used his mathematical and statistical skills to help determine the optimal degree of fragmentation of artillery shells. Officers flew back to the U.S. in the middle of the Battle of the Bulge to get his advice on the trade-off between the likelihood of hitting the target (the more fragments, the better) and the likelihood of doing serious damage (the fewer and bigger the fragments, the better).

Emboldened by this work, economists began to apply their number-crunching skills to the postwar market. Chicago graduate student Harry Markowitz devised a model for picking stocks that was, in Friedman's estimation, "identical" to his artillery-shell-fragmentation trade-off. And in the late 1950s, scholars at Chicago and the Massachusetts Institute of Technology became enamored of the idea that stock-market movements were, like many physical phenomena, random.

The two strands of statistics and pro-market ideology came together in the mid-1960s. It was the great MIT economist Paul Samuelson who made the case mathematically that a rational market would be a random one. But Samuelson didn't share Friedman's political views, and he never claimed that actual markets met this ideal. It was at Chicago that a group of students and young faculty members influenced by Friedman's ideas began to make the case that the U.S. stock market, at least, was what they called "efficient."

In this telling, the recent financial market meltdown is the sorry end to a very 20th-century kind of story, in which our capacity for scientific innovation far outpaces our actual body of scientific knowledge (particularly our knowledge of the consequences of the innovations), and it takes a series of calamaties and near-calamities to bring the two more in line with one another. You can go down the list from nuclear proliferation to global warming and the same themes keep popping up. Very smart of Fox, I think, to see those parallels in this story.

--Noam Scheiber