New research deviates from traditional economic views

Since the 1980s, policymakers in America have been attempting to deregulate economic markets. According to researchers Michael Goldberg, the Roland H. O'Neal Professor of Economics at the University of New Hampshire, and Roman Frydman, professor of economics at New York University, these policies are based on false assumptions.

Goldberg and Frydman presented their Contingent Markets Hypothesis recently in the paper "Efficient Markets: Fictions and Reality" to world economists and financial leaders at the inaugural conference of the Institute for New Economic Thinking at King's College in Cambridge, UK.

According to Goldberg, popular economic theory and models imply that markets are perfect and the future unfolds mechanically.

They suggest that prices fluctuate randomly around true fundamental values, and individuals have a perfect knowledge about how change will occur. If this is true, then policy will accordingly hold that officials should leave markets completely unfettered and reduce regulation to a minimum.

"However, if you talk to anybody in financial markets, they will say that they have imperfect knowledge about processes driving outcomes and future changes," Goldberg said. "A lot of the change that will happen is not foreseeable."

This has led many policy makers and economists to take the exact opposite view - that markets are akin to casinos - irrational, wholly imperfect and prone to manias and emotions – and it is the government's job to intervene. According to Goldberg, he and Frydman developed an intermediary stance between the two extremist camps with their Imperfect Knowledge Economics.

"It says we are going to see swings because we have imperfect knowledge," Goldberg said. "Markets do a good job in setting prices - in fact there's really no other option than to rely on financial markets in setting prices.

"But, because trading is based on imperfect knowledge, markets are also imperfect, and sometimes price ranges can be too. Only when we have excessive movement is there a role for government."

Unforeseeable events like the earthquake in Haiti can cause prices to deviate from what history dictates are sustainable values.

These relationships cannot be derived mechanically from old ones. When this happens, unpredicted uncertainty, panic and freezing of markets can occur – such as when large upswings are followed by drastic downturns.

"Eventually markets will correct themselves on their own, but sometimes these corrections are sharp and can lead to crises," Goldberg said. "When, and if, asset prices move excessively away from estimates of benchmark levels, only then should the regulators try to limit and push asset prices back to a level more consistent with evaluations."
Goldberg said this is exactly what triggered the current economic crisis.

"One of key factors that led to this crisis was the boom and bust in housing markets," he said. "The Contingent Markets Hypothesis implies that we are going to see swings; it's what markets do. It's really hard to forecast when swings will begin and end, with all the change that is constantly going on. Forecasting would help society to allocate money. Because all of this behavior is based on imperfect knowledge, sometimes swings will go too far, which is what happened. The correction triggered the crisis."