Justin Fox of Time Magazine explains the appeal and the downfall of the rational market theory and tells us the next great economic theories and investment models.

Question: What is the appeal of the rational market theory

Justin Fox: The basis of the theory is that Wall Street knows what it’s doing: that prices move on stock markets in particular, but financial markets in general, for a good reason—because all these investors and speculators are bringing all this information and opinion to bear, and are therefore delivering the best possible assessment of what a particular stock or bond or whatever else is worth. And part of the attraction of is, at some level, it is at least partly true. Stock markets are not completely driven by noise; they are not completely driven by irrationality. If they were, I think we would have decided to get rid of them at this point. Although, I guess a lot of people make money often so you never know. But, still, there’s some element of rationality and reflection of fundamentals going on in market behavior, so that’s one reason why it’s attractive.

The other reason why it’s attractive—especially the version of it that was born or reborn in 1960’s and really became incredibly influential in 70’s and 80’s and 90’s—it just makes life so much simpler. If you just simply go from the starting point that financial market prices are right, then you can do so many great things. You can calculate the cost of capital really easily if you’re a corporate decision maker trying to decide whether you want to do an investment or not. You can pick out an investment strategy that makes sense, that balances and risk and reward more appropriately, very easily. You can basically approach the market in this scientific fashion that can be taught to other people and handed down to other people. It isn’t all about gossip or people’s strange opinion. It’s the scientific straightforward guide to decision-making in and around the market.

Question: What alternatives to the rational market theory are being put forward?

Justin Fox: One of the fascinating things that’s going on right now is a bunch of economists, Paul Krugman and Brad DeLong among them, are trying to come up with pretty much rational explanation of bubbles: how bubbles work and what the interaction is between the leverage and bubbles, and what causes them. I’m fascinated by that. I don’t know if it will deliver any real answers, but it is an attempt to use the fact that—even [when] people who, in their individual position as a hedge fund manager or whatever, are behaving entirely rationally need to maximize their own well-being—it creates this system where markets go bonkers, and I think that the lessons that will probably come out of that is: leverage is dangerous. That’s really interesting to me.

Other areas that there are some people who would go head over heels for, and I’m interested in it and I talked about it at the end of the book, is this idea that maybe we can come up with different ways of modeling market behavior that sort of take the fact that investors are constantly learning, but at the same time that the markets that they are trying to understand are constantly changing—so it’s this constant process that [is] moving towards getting things right, but then markets continue moving away from that, so there is never any perfect moment. There is never equal equilibrium. And lots of people, some of them physicists, some of them economists, try to put together these various “adaptive markets” or, I mean, complexity is another term for part for this. It was very fashionable in early 90’s, everybody sort of forgot about it for a while, and now it’s back. I just don’t know where it leads. Nobody got any answers out of it yet as to how markets behave.

Question: What do you think of new investment models such as social lending?

Justin Fox: All these people want to come by and visit an economics columnist for Time, and I’ve been talking to a lot of these people. There is some potential for creating these, what basically amounts to securitized lending, but in a more transparent straightforward way. But I don’t know. At some level, I think we are still figuring out how a financial system actually works. We thought for a little while that all of this stuff has been solved by moving everything out of institutions like banks into markets. But it is just not that easy—debt markets turn out to be incredibly dependent on the rating agencies to tell investors what to buy or not, and they were worse than banks at determining what’s a good loan and what’s a bad loan. I just don’t know what kind of institutions are going to exist. It is very intoxicating to hear about a place like Kiva, which has all these people in the US making tiny loans to somebody starting a bakery in Peru. It’s all very cool, although Kiva has been so successful in part because there’s no attempt actually to make a profit off it. So maybe it’s not a business model, it’s just this new model for organizing charity.

Recorded on: June 30, 2009