Every once in a while a book from outside the discipline can help tremendously to make sense of the way how economists interact with the rest of the real world. Roger Lowenstein’s book about “The Rise and Fall of Long-Term Capital Management” – subtitle: “how one small bank created a trillion-dollar hole” – is such a book. Lowenstein recounts the history of this hedge fund, which was peculiar because it was run by a team that included economists, Nobel prize-winning ones. That did not help much – the Fund lived only 4 years. So much for the efficient market hypothesis and other financial theories that are built on shaky assumptions like the capital asset pricing model. Lowenstein describes how “the professors” believed that their theories were “true” and acted accordingly, with first excellent and then disastrous effects. The book contains some very nice sentences which sum up the whole thing, like this one:
But the trades were quite risky nonetheless. For one, forecasting the market’s volatility is notoriously dicey – unless you believe that the past is a reliable predictor of the future.
This connects to the discussion of ergodicity in the Post-Keynesian literature (Paul Davidson on video). LTCM finally lost out because it had positions locked in that it couldn’t get out of at an acceptable price. Other players were deliberately betting against LTCM’s trades, which meant that all its trades were correlated – something not foreseen by “the professors”. In the end, the whole episode has been something which did not really surprise me. There is one Keynes quote which explains a whole lot:
The market can remain irrational longer than you can remain solvent.
There is another by Benjamin Graham:
Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.
More or less, these two quote sum up the whole LTCM episode. It is nevertheless exciting to read Lowenstein’s book to get all the details. The efficient market hypothesis, which in my view is nothing else but abstract nonsense (and I am not sure whether Paul Samuelson would not have agreed; read his conclusion here), was declared to mean that “markets work” (WSJ, 1997).
The opposing view was held by Soros: “He felt they [markets] interacted with, and were reflective of, ongoing events”. Soros is quoted: “You have outlying phenomena that you can’t anticipate on the basis of previous experience”. Very true. And those at LTCM who disagreed have lost their shirt.