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Here’s a quick thought exercise. Assume that in your town or city, or even country, voters are evenly divided between two public policy decisions. Let’s ignore what the choices are, but instead, I will tell you that one choice is a more abstract, theoretical choice, while the other is grounded in real-world understanding. Given your biases, which would you be inclined to support?

There are few guarantees in life, however, if we were to ask the platonic financial economist, he or she will always and forever—one million times out of a million—argue for the abstract decision. To many financial economists, all investors’ problems are simply a problem of emotions. The people always suffer from insufficient self-denial.

It’s a huge mistake to interpret the judgments of the financial markets as moral judgments, but this happens all the time. To choose an obvious example, it’s easy to think the collapse of the Internet boom was punishment for earlier greed. You would get few thoughtful people to admit to that in public, but they do, perhaps unwittingly, believe it.

You can also find this in the financial media all the time. For example, when the housing market soars, it’s due to greedy, irrational Americans bidding up prices. We're told that the root cause is always the victory of emotions over reason.

But what happens when the bond market soars? Nope, no judging here. Bond traders are somehow always right. You can wait a long time before you will hear the words “bond bubble.” The same holds true for oil.

The uncrowned king of this school of thought is Robert Shiller of Yale. The best part of being a member of this school is that you never have to be right. One only needs to look worried. Finger-wagging is good too. Also, you can earn extra points if you find new things to worry about.

But when you closely look at investment bubbles, they’re often less irrational than they appear. Remember, eBay is higher now than it was six years ago, but GE is down. Which one was the bubble? I have my answer.

The real mob mentality is crowd of observers trying to be the lone voice of reason in a sea of madness. Consider this Lawrence Summers' editorial from earlier this week:

The headlines and opinion writers focus on how the U.S. is badly bogged down in wars in Afghanistan and Iraq; on an increasingly unstable Middle East and dangerous energy dependence; on nuclear proliferation that has already occurred in North Korea and that is coming in Iran; on the potential weakness of lame-duck political leaders; on record global trade imbalances and rising protectionist pressures; on increased levels of public and private-sector borrowing combined with record low saving in the United States; and on falling home prices and middle-class economic insecurity.

At the same time, financial markets are pricing in an expectation of tranquility as far as the eye can see. Stock prices in the U.S. are at all-time highs (uhm...no Larry, they’re not). The risk premiums that corporations or developing countries have to pay to borrow money are at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options are near record lows.

Summers has brought professional worrying to a new level. Our reason to be concerned is that...(drumroll)...we’re overly cautious! He’s confusing the lack of volatility with a carefree attitude. Actually, it’s just the opposite. But Summers’ argument is that overcautiousness is the very reason to be worried.

When you turn financial analysis into moral judgments, you misunderstand an important aspect of the market’s nature. The market has zero moral intelligence. The market simply moves capital from less productive assets to more productive. Trying to find a morality tale beneath the suface won't help you explain what's going on.

Posted by edelfenbein at December 28, 2006 9:34 AM