TRADING
CENTER
Breaking Views

Markets don't kill investors - bad decisions do

Prevailing theories want to put the blame on the system. But false assumptions in modern thinking are what really caused the crash.

By Martin Hutchinson, breakingviews.com

(breakingviews.com) -- Billionaire George Soros has pledged $50 million to a new foundation that will seek an alternative to what he calls "market fundamentalism."

But the false assumptions in modern financial theory -- abetted by laxity in monetary policy and government meddling in housing -- played a much bigger role in the crash of 2008 than free markets did.

Soros, who famously made $1 billion betting against the Bank of England in 1992, is a long-standing critic of free markets. It is thus unsurprising that he blames an excess of laissez-faire capitalism for last year's financial meltdown and the subsequent severe recession.

Yet the fingerprints of government are all over the crash, perhaps especially in the U.S. The Federal Reserve pursued an interventionist monetary policy from 1995, expanding M3 money supply significantly faster than growth in nominal GDP, and relatively faster than in the inflationary 1970s. That produced a series of asset bubbles.

Meanwhile, the government's explicit and implicit support of housing finance through Fannie Mae, Freddie Mac and in other ways helped produce a mortgage market in which originators could avoid responsibility for credit risk, even as they lent with the government's blessing to increasingly stretched borrowers.

Even on Wall Street, the appearance of free markets was deceptive. The prevailing modern financial theory rested on a number of erroneous assumptions. It assumed not only that price movements were random, but that extreme events were so unlikely they could be almost completely ignored.

Financial models mostly assumed that volatility was constant or varied only slowly, ignoring the numerous historical examples of crisis situations when it jumped discontinuously. And the theory assumed that complex correlations could be measured with precision, and did not vary much.

Given these errors, it's not surprising that a market that rested on modern financial theory went wrong. Soros may be right that economic theory needs a rethink. But what's needed isn't an alternative to free markets. It's a free market system that works. To top of page

CompanyPrice% Change
UAL Corp 15.38 17.67%
AMR Corp 8.27 12.98%
Continental Airlines Inc 19.23 10.79%
US Airways Group Inc 6.43 8.43%
Feb 9 3:54pm ET †
IndexLast% Change
Dow Jones10,058.641.52%
Nasdaq2,150.871.17%
S&P 5001,070.521.30%
10yr97 25/32Yield: 3.64%
Feb 09 †
CompanyPrice% Change
Electronic Arts Inc 15.90 -9.09%
Sanmina Sci Corp 13.70 4.82%
Cablevision Systems Corp 26.10 3.78%
Sprint Nextel Corp 3.62 3.13%
Feb 9 3:58pm ET †
More Galleries
10 sages read the future of print What becomes of the printed word? What's the fate of companies that produce periodicals and books? Here's what 10 media and tech luminaries think. More
Buy Scarlett Johansson's hilltop manse Even starlets are subject to the faltering real estate market. Just three years after buying her Los Angeles home, Johansson is selling it for $2 million less than she paid. More
I stopped looking for work The number of discouraged job seekers is at an all time high. These readers tell us what it's like to give up on the job search. More
Sponsors

© 2010 Cable News Network. A Time Warner Company. All Rights Reserved. Terms under which this service is provided to you. Privacy Policy. Advertising Practices.
Copyright © 2010 BigCharts.com Inc. All rights reserved. Please see our Terms of Use.
MarketWatch, the MarketWatch logo, and BigCharts are registered trademarks of MarketWatch, Inc.
Intraday data provided by Interactive Data Real-Time Services and subject to the Terms of Use.
Intraday data is at least 20-minutes delayed. All times are ET.
Historical, current end-of-day data, and splits data provided by Interactive Data Pricing and Reference Data.
Fundamental data provided by Morningstar, Inc..
SEC Filings data provided by Edgar Online Inc..
Earnings data provided by FactSet CallStreet, LLC.