THE FREE MARKET FAIRY FAILS AGAIN

(h/t Mark Thoma)

Writing in the NYT, Robert Schiller mentions a mathematically sound description of herd behavior that contradicts Efficient Market Theory:

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem.

Even in a situation where each person has a 60% chance of being correct about an economic question (e.g., in a bubble or not?), there's a 37% chance that a bubble will form:

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.

As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

This theory assumes that people ARE rational, so if we include the clear findings from behavioral finance that people often aren't, we have a devastating rebuttal to a favorite Free Market Fairy delusion:

This theory poses a major challenge to the “efficient markets” view of the world, which assumes that investors are like independent-minded voters, relying only on their own information to make decisions. The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others.