You may remember that in 2008-2009, as the worst financial crisis since the Great Depression was ravaging stocks, real estate, commodities and other "can't lose" asset classes, many called into question traditional economic models -- because they did little to warn us of the approaching doomsday.
So, today, we are starting a new series: "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president gives detailed explanation of why the traditional financial models failed -- and, very importantly, why they doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)
It's an important series. Read it carefully -- it will explain many "paradoxes" you see in financial markets daily and open your eyes to the shortcomings of modern economics. Here is Part I; come back next week for Part II.
The Socionomic Theory of Finance
The Conventional Error of Exogenous Cause and Rational Reaction
By Robert Prechter
Every time there is a recession, observers grumble about economists' methods. The deeper the recession carries, the louder the grumbling. The reason that widespread complaints occur only in recessions is that economic forecasters as a group never, ever anticipate macroeconomic changes. Their tools don't work, but consumers of their commentary do not notice it until recessions occur, because that is the only time when everyone can see that the methods failed. The rest of the time, when expansion is the norm, no one notices or cares.
Ironically, in the long run, the complaints never stick. Once the economy begins expanding again, everyone forgets about their old complaints. The media resume quoting economists, despite their flawed methods, and they are once again satisfied that their commentaries make perfect sense. There is a good reason for this recurring behavior. At the end of this exposition, we will explore why it happens, over and over, and why it probably will never cease.
The recent/ongoing economic contraction is the deepest since the 1930s, so the complaints about economists' ideas are the most strident since that time. Figure 1 shows how one publication expressed this feeling following four quarters of negative GDP (and just before the recent partial recovery began).
The rebound in the economy since July [2009] has brought a collective sigh of relief from the economics profession. Yet the bankruptcy of conventional methods for predicting trends in the macro-economy has not gone away. Even in this cycle, it has only begun to manifest.
Economists polled by USA Today and The Wall Street Journal are back to normal, which is to say unanimously optimistic, for at least a full year ahead. When these optimistic forecasts fail yet again and the bear market and depression deepen, economists will find themselves even more on the defensive. Critics' complaints will become even louder. By the bottom, everyone will agree that economic theory is worthless. Then, in the recovery, everyone will go back to using it again.
Nevertheless, this brief time of doubt and criticism affords socionomics an opportunity to be heard. People listen only when they are emotionally attuned to alternative ideas, and we have such a time now. For over 30 years, I have argued that the socionomic model of social causality is not only beautiful and elegant but also true. A subset of socionomics, the socionomic theory of finance (STF), is consistent with empirics, and to the extent of our ability as theoreticians, internally consistent as well. Other theories of finance fail on one or both grounds. This series will provide an overview of STF so that you can judge these aspects for yourself.
Few people are able to find socionomic theory accessible until they first see that their old way of thinking is flawed. So we will begin with a look at the reigning ideas, which are based on mechanistic causality, to which most humans naturally default, even in the social realm.
The Fundamental Flaw in Conventional Financial and Macroeconomic Theory
Conventional financial theory relies upon the related and seemingly sensible -- indeed seemingly imperative -- ideas of exogenous cause and rational reaction. In a limited but comprehensive survey, we find that modern academic papers, studies, hypotheses and theories about social motivation -- in the fields of finance, economics, politics, history and sociology -- begin with these ideas, whether they are stated explicitly or not.
Most of the time, these ideas are stated explicitly. Papers are packed with discussions of and conjecture about "information flows," "exogenous shocks," "fundamentals," "input," "catalysts" and "triggers." Even hypotheses that make room for mass psychology embrace ideas such as "positive feedback loops" under the assumption that even if social mood were to turn on its own accord, resulting events have the power to reinforce social mood and, more narrowly in the realm of finance, to affect aggregate investors' buying and selling decisions. Papers on behavioral finance that describe non-rational behavior nevertheless treat it as an exception or departure from rationality, objectivity, utility maximization and market equilibrium, all of which are characteristic of the exogenous-cause/rational-reaction paradigm. This paradigm is accurate and useful in microeconomics but inaccurate and useless in fields of finance or so-called macroeconomics (which as I hope to show is really a subset of socionomics).
The Efficient Market Hypothesis (EMH) and its variants in academic financial modeling as well as the entire profession of applied economics rely at least implicitly but usually quite explicitly upon the bedrock ideas of exogenous cause and rational reaction. Stunningly, as far as I can determine, no evidence supports these premises, and, as the discussion below will show, all the evidence that we socionomists have investigated contradicts them.
Later in this exposition I hope to show that every proposed relationship that fails under an exogenous-cause explanation becomes a success when given a socionomic explanation.
(Next: Robert Prechter tests "Claim #1: 'Interest rates drive stock prices.'")
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