Free market economics is famously predicated on “market rationality,” the idea that each participant in the economy acts as a coolly reasoning “homo economicus” in purchase and investment decisions. Yet as the disintegration of the 1995-2007 credit bubble continues it is becoming more and more obvious that in several areas economic decision-making during this period has been highly irrational. There are no complete solutions to this problem, but there are palliatives.

Subprime mortgages themselves exemplify irrational markets, yet the participants’ activities at each stage were economically in their own rational interest:

• Low income consumers took on mortgages they had no prospect of affording because they believed from the experience of others that house prices would rise sufficiently to bail them out. In any case being often near bankruptcy the potential profit from successful speculation appeared to them greater than the potential loss from default.
• Mortgage brokers sold subprime mortgages because they got a commission for selling them and were not responsible for the credit risk.
• Investment banks packaged the subprime mortgages into multiple-tranche mortgage backed securities because they received fat fees for doing so and again had no real responsibility for the credit risk.
• Rating agencies gave the upper tranches of mortgage debt favorable ratings, because they made a great deal of money from providing ratings for asset backed securities, needed to keep in the favor of the investment banks who brought them this attractive business, and had mathematical models (either their own or the investment banks’) “proving” that the default rate of the securitized mortgages would be low.
• Investment bank and rating agency mathematicians produced models “proving “ that default rates would be low, ignoring the real-world correlations between defaults on low quality consumer debt, because they were well paid to do so – the alternative was to return to a miserable cheese-paring existence in academia.
• Finally the investors bought asset backed securities because they could achieve a higher return on them in the short term than their borrowing costs, and could tell their funding sources (in the case of hedge funds) or bosses (in the case of foreign banks) that they were taking very little risk because of the securities’ high rating.

Each step of the process was rational (albeit operating on imperfect information), yet because incentives were hopelessly misaligned, the final result was an irrational market, in which loans that would not be repaid were securitized and sold to investors seeking an above-market return at below market risk, a combination that in the long run ought not to exist without the application of extraordinary intelligence.

In the credit card business, currently equally likely to subside into a slough of defaults, the rationale was a little different. Here the subprime credit card consumer had no rational basis for believing that anything he bought with the card would become sufficiently valuable to pay off the card debt. Instead, the credit card business became a tribute to the power of advertising; by sending out credit card solicitations weekly to every deadbeat in the United States, the card companies were able to persuade consumers that taking on too much debt was a perfectly natural means of acquiring the consumer goods or vacations they craved. “Homo economicus” would have rejected excessive card offers; in the real world unsophisticated consumers are deluded into thinking that credit card debt is manageable, and that their income will increase sufficiently to service it. As with subprime mortgages, credit card lenders would not have been so aggressive if the assets had resided on their balance sheet, but through securitization they too could delude themselves that they were sloughing off the credit risks onto anonymous third parties.

The derivatives market was also an area in which irrationality held full sway. Here the fault was excessive belief in mathematical models. It was attractive to traders and to operating management to pretend that markets were fully stochastic random walks – after all, Nobel prizes had been given for this assertion – and to assess Value at Risk on that basis, ignoring the reality that markets often behave in a highly non-random manner. By doing this, management could claim to investors that risk positions were in reality modest, while traders could bet the future of the institution on gambles that may go spectacularly wrong every few years, but in the meantime keep the investor capital and the bonuses flowing in.

When in mid-August Goldman Sachs announced that a “25 standard deviation event” had caused the value of its quantitative fund to drop 30%, the implication was that the subprime mortgage crisis had caused the market to behave in some wholly unexpected pathological manner, normally to be anticipated only two or three times in the history of the universe. In reality such “25 standard deviation events” happen two or three times a decade and are perfectly normal. The abnormality, in which the market lost its mind, was in Goldman basing its reputation and its investors’ wealth on such obviously inadequate mathematical techniques.

On the funds management side, fiduciary investment in hedge funds and private equity funds is equally an example of market irrationality. Pension funds in particular have an exceptionally long time horizon, so investing in short term oriented hedge funds was especially inappropriate. It was obvious also that private equity funds depend crucially on the availability of an active and receptive stock market for exit from their investment positions and so in no sense represent a “separate asset class” from conventional US equities. While private equity fund and hedge fund sponsors have attempted to hide the reality of their funds’ mediocre returns, the truth has been apparent with a little digging for several years, which is why both types of funds market their returns on a “top quartile” basis, pretending as in Garrison Keillor’s Lake Wobegon that all funds are above average.

The reality is that only the remuneration of the sponsors is above average, far above that for managers of conventional equity funds, and rendered especially egregious by the practice of managers extracting their 20% “carry” BEFORE the investments have actually been sold, thus leaving the fund illiquid and the investors wholly dependent on exits that might never be achieved. Again, there was nothing irrational in Wall Street selling these new funds; the irrationality lay in institutional investors buying them. Once it has become obvious what devastation has been wreaked on beneficiary pensions from these investments, it is likely that some of the more enthusiastic fiduciary participants will find themselves in class action court, if not in jail. The U.S. judicial system is these days particularly unforgiving of market failure, as Enron’s Jeffrey Skilling discovered.

Finally, there is the explosion in top management remuneration over the last two decades. It is folly to imagine that US top management is many times better than in the 1980s, but yet it is paid many times as much in real terms. The initial boost came from stock options, which management persuaded the accountants could reasonably be left off the income statement. Here both management and the accountants were properly market motivated; the irrationality arose from the failure of the policing institutions such as the SEC to prevent such looting of shareholder wealth. More recently, management has been able to increase its remuneration by threatening the stockholders with defection to a private equity buyer. This has resulted in the breakup of a number of long established companies, almost certainly with highly deleterious consequences for the U.S. economy. Again, warped incentives produced behavior that was from a market point of view mindless.

From the above examples, it is clear that market madness derives from a number of causes, but primarily from misaligned incentives, excessive salesmanship and poor regulation. The decade of cheap money has exacerbated the problem; behavior that would have been punished by bankruptcy before it became widespread has been allowed to spread throughout the world’s markets. The behavioral factors that sophisticated economists today recognize as important modifiers of the pure free market paradigm have become dominant, and have pushed the world economy a considerable distance from an optimal state.

The market will never be completely rational, and nor should we expect it to be. Equally, market irrationality has in the last decade enriched a lot of thoroughly unpleasant people at the expense of the economy as a whole. To cure the problem, government action is required only at the margins, tightening regulation on, for example, the marketing of credit cards to end the practice of unsolicited credit offers, so dangerous to the financially vulnerable and unsophisticated.

More important, money must be kept tight, in order that periods of irrational speculation do not extend themselves as they have done since 1995. It is likely that this will also involve a substantial shrinkage of the financial services industry, even if not to its 1970s size of approximately half its present proportion of the economy. The last decade has demonstrated that arcane areas of financial services are particularly vulnerable to rent seeking sales operations, and the normal weeding out that occurs in downturns is impossible if bull markets are prolonged by a decade or more.

In many cases, if core participants had acted responsibly, market irrationality would not have occurred, but the overly responsible get weeded out of the financial services business in a decade-long bull market. It is bull markets not bear markets that produce sharp increases in dishonesty and rent seeking.

In future, if after say 5 years the stock market is continuing to soar, the Fed should bring it back sharply to earth by a rise in short term interest rates. Former Fed Chairman Alan Greenspan should have done this when he spotted “irrational exuberance” in December 1996; it is to his everlasting disgrace that he didn’t. Only by such a grounding can the bubble operators be weeded out and rationality returned.

On days when the market drops, financial commentators are filled with gloom as they agonize over the possibility that the US economy is headed into recession and the markets into freefall. Fear not; market freefall and economic recession will sweep away the irrationalities of the last decade, and those uninvolved in scams will find their own wealth and share of the economy increasing comfortably.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)