A Random Walk Through The Rubble

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How much did we lose?” my wife asked me on the day the stock market sank like a stone last October. I did some quick arithmetic and answered, with remarkably good cheer under the circumstances, that we had lost only a little more than two times our annual income.

To cushion the blow, I quoted Mark Twain. “October,” he wrote in Pudd’nhead Wilson . “This is one of the peculiarly dangerous months to speculate in stocks. … The others are July, January, September, April, November, May, March, June, December, August and February.”

My wife was not amused. “Will we have a depression?” she asked. We had intended to go out for dinner, but even a modest meal at the Chinese restaurant across the street suddenly seemed extravagant. That decision, multiplied ten billion times, was what the experts were talking about on television, using phrases like “the effect on consumer spending.”

Will we have a depression? was the question Jim Lehrer asked the Nobel Prize-winning economist from MIT. He used more elegant language, but I sensed that the Nobel Prize-winning economist wanted to say exactly what I had said when my wife asked the same question: “How the hell am I supposed to know?”

Later that night I sat down to see what I, an intelligent layman, could learn about stock market crashes and depressions from people who had really studied them.

For the general reader, John Kenneth Galbraith’s The Great Crash , 1929, originally published in 1955, remains the most readable—if not the final—account of the market collapse that ushered in the Great Depression. Galbraith’s gift for tart commentary makes him an ideal guide to a period in which, as he says, “great drama” was joined with “a luminous insanity.”

Galbraith takes special satisfaction in the discomfiture of the “official optimists” whose pronouncements fueled the bull market. Comments by Bernard Baruch (“the economic condition of the world seems on the verge of a great forward movement”) and Professor Irving Fisher of Yale (“stock prices have reached what looks like a permanently high plateau”) prepare us for the response of Herbert Hoover after the market plunged: “The fundamental business of the country … is on a sound and prosperous basis.”

In general, Galbraith comments, “the greater the earlier reputation for omniscience, the more serene the previous idiocy, the greater the foolishness now exposed.” But his book is not merely a study of foolishness in high places. It is a study of universal foolishness. “No one was responsible for the great Wall Street crash,” he concludes. “No one engineered the speculation that preceded it.” That speculation was entered into freely and even joyfully by hundreds of thousands of individuals who “were not led to the slaughter” but “were impelled to it by the seminal lunacy” that convinces people that they are destined “to become rich without work.”

When he considers whether the crash caused the Depression, Galbraith grows cautious. The economy, he notes, had begun to weaken well before the dive. The distinguishing feature of the crash of ’29 was that “the recession continued and continued and got violently worse.”

To a large extent, Galbraith finds, things got worse because in the years after the crash, “the burden of reputable economic advice was invariably on the side of measures that would make things worse.” Galbraith notes in particular the unwillingness of government officials to pump money into the economy even though “the country was experiencing the most violent deflation in the nation’s history,” and he notes the commitment of both political parties to a balanced budget (which ruled out deficit spending by the government to reinvigorate the economy). The rejection of both monetary and fiscal measures “amounted precisely to a rejection of all affirmative government economic policy,” to “a triumph of dogma over thought” that converted the crash into a catastrophe.

Having examined the views of a celebrated Keynesian, I turned to celebrated monetarists. In Free to Choose , Milton and Rose Friedman have a chapter on the crash that is addressed to the general reader. Their conclusion? “The depression was not produced by a failure of private enterprise, but rather by a failure of government.”

The Friedmans emphasize the role of the Federal Reserve System, which regulates the supply of money. After the crash, they argue, the Fed should have expanded the money supply to counter the contraction. Instead, it “allowed the quantity of money to decline slowly throughout 1930.”

The Fed also failed in its response to the series of bank failures that began in 1930. It should have purchased government bonds on the open market to provide banks with the cash to meet the demands of their depositors. Instead, the Fed “stood idly by and let the crisis take its course,” with the result that ten thousand banks closed and the nation experienced “a monetary collapse without precedent.”

The Friedmans and Galbraith agree that the crash of ’29 did not precipitate the Depression. But they differ sharply in the lessons they draw from the crisis. Galbraith favors the kind of economic initiatives we associate with the New Deal. The Friedmans lament the “rapid growth of government” that began with the Roosevelt administration and suggest that the shift of opinion in favor of government intervention in the economy “resulted from a misunderstanding of what had actually happened.”

I was still trying to reconcile the monetarist and Keynesian perspectives when Charles P. Kindleberger, professor of economics emeritus at MIT and the author of a well-regarded book entitled Manias, Panics, and Crashes , offered his thoughts on the subject in The New York Times . “Neither monetarism nor Keynesianism is much help in understanding either the 1929 or the 1987 crash,” Professor Kindleberger writes. “Investor psychology is to blame.” In his book he offers an account of the onset of the Depression that focuses on “instability of credit and fragility of the banking system”—factors that have, in his view, “unaccountably slipped into disrepute” during the monetarist-Keynesian debate.

At this point the intelligent layman decided he had had enough. If these economists are so smart, 1 thought, how come they can’t even agree about what caused the Depression?

Another question bothered me even more. It was a question about the efficient-market theory, which is my absolute favorite of all the fancy theories that 1 learned in business school.

According to one of its chief proponents. Burton G. Malkiel, the former dean of the Yale School of Organization and Management, the basic idea of efficient-market theory is that “securities markets are very efficient in digesting information.” When information arises that affects a company’s prospects, stock prices immediately adjust to the news. “Thus, it is useless to try to use either technical analysis (an analysis of past price patterns in an attempt to divine the future) or fundamental analysis (an analysis of a particular company’s earnings, its future prospects, etc.…) to attempt to beat the market.”

If these economists are so smart, I thought, why can’t they even agree about what caused the Depression?

The efficient-market theory implies that the price movements of stocks will be highly erratic, like a “random walk” (which is to say, like the sequence of outcomes in a series of coin tossings). Erratic movement follows from the assumption that prices incorporate all known or predictable events. Only unpredictable events matter, and they must occur randomly or else we could predict them.

This may not sound especially exciting, but it leads directly to the conclusion that, as Malkiel puts it, “a blindfolded chimpanzee throwing darts at The Wall Street Journal could pick a portfolio of stocks that would perform as well as those carefully selected by the highest priced security analysts.” The mathematics gets a little complicated, but the basic point is that all those brilliant analysts neutralize one another.

Do the actual movements of stock prices over time move randomly? You bet they do. What about that blindfolded chimpanzee? Well, a blindfolded chimpanzee throwing darts would give you the equivalent of an unmanaged portfolio. And study after study has shown that an unmanaged portfolio that mirrors a broadly diversified stock index will outperform the managed portfolio of the average pension fund or mutual fund.

I love efficient-market theory, and I truly believe that investing in an unmanaged “index” fund, with minimal management and brokerage fees, makes more sense than most of the clever things that people do with their money. But a one-day decline of 508 points in the Dow-Jones industrial average raises a serious question in my mind. Efficient-market theory implies that just before the Stock Exchange opened on Monday. October 19, the thirty stocks in the Dow-Jones industrial average were efficiently and rationally priced at 2,246 and that at the end of the same day, those same stocks were efficiently and rationally priced at 1,738. How could that be? Any rational observer can see that it’s crazy.

“Nothing is more suicidal.” John Maynard Keynes wrote, “than a rational investment policy in an irrational world.” Keynes was a famously successful investor who spent half an hour in bed each morning making stock selections. His trick was to guess where the crowd was going before the crowd itself knew—or, as he put it, “to guess better than the crowd how the crowd will behave.”

It’s not as easy as it sounds. After getting burned in one panic, Sir Isaac Newton commented. “I can calculate the motions of heavenly bodies, but not the madness of people.” Markets and the madness of people—I’ll write about that another time. Meanwhile. I would like to hear from anyone who can restore my faith in the efficient-market theory. And my wife would like to hear from anyone who can answer a simple question: Should we buy or sell, and when?