The Invention of Mechanical Markets
ALTHOUGH THE raison d’être for financial markets implies that they cannot assess asset values perfectly, over the last four decades of the twentieth century, economists developed an approach to macroeconomics and finance that implied that financial markets allocate society’s capital almost perfectly. To reach this conclusion, economists constructed probabilistic models that portray an imaginary world in which nonroutine change ceases to be important; indeed, it becomes irrelevant.
An economic theory of the world that starts from the premise that nothing genuinely new ever happens has a particularly simple—and thus attractive—mathematical structure: its models are made up of fully specified mechanical rules that are supposed to capture individual decisionmaking and market outcomes at all times: past, present, and future. As one of the pioneers of contemporary macroeconomics put it, “I prefer to use the term ‘theory’ … [as] something that can be put on a computer and run … the construction of a mechanical artificial world populated by interacting robots that economics typically studies” (Lucas, 2002, p. 21).
To portray individuals as robots and markets as machines, contemporary economists must select one overarching rule that relates asset prices and risk to a set of fundamental factors, such as corporate earnings, interest rates, and overall economic activity, in all time periods. Only then can participants’ decisionmaking process “be put on a computer and run.” But this portrayal grossly