I once asked my friend who’s a higher-up at a hedge fund if he thought that markets were rational. He told me “No one in the financial world believes that markets are rational.” It’s always been surprising to me that professional economists do. Krugman (h/t Atrios):
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.
I’ll spare you the details of my theory that many economists like the idea of high-powered math because they’re failed mathematicians, partly because you might find it offensive and partly because it doesn’t fully explain the problem here. Our society, especially its elites, has some weird fixation with the idea that we’re the best of all possible societies. Our markets work perfectly, we have the best healthcare in the world, and soon history will end as the rest of the world emulates our perfect societal system.
I could go on and on, but I’ll stop. The point here is that it’s hardly surprising that the same people who believe American society is the ideal final state for civilization would also have childlike naivete about how well markets work. Economists are especially disposed to believe all this crap because they’re paid so well. When you’re paid 300K a year to spin fantasies, it’s pretty easy to believe that you live in a perfect world and that your beautiful fantasies are the truth.