When theory meets reality


It's been said that a Frenchman is one who when observing something working in practice will ask, yes, but does it work in theory? Ronald Reagan adapted this truth to make it a quip about economists. Somewhat cruel but possibly fair, as this paper makes clear:

Many stock market analysts think that in 1929, at the time of the crash, stocks were overvalued. Irving Fisher argued just before the crash that fundamentals were strong and the stock market was undervalued. In this paper, we use growth theory to estimate the fundamental value of corporate equity and compare it to actual stock valuations. Our estimate is based on values of productive corporate capital, both tangible and intangible, and tax rates on corporate income and distributions. The evidence strongly suggests that Fisher was right. Even at the 1929 peak, stocks were undervalued relative to the prediction of theory.

Ed Prescott received his Nobel Prize in economics the year after this paper was published. Which goes to show that not everything written by incredibly bright people is necessarily incredibly bright.

For the basic rule of thumb of any science is that when theory conflicts with reality it's theory that is wrong, not reality. And when we apply this insight to economics, to markets, we really do need to remember this insight.

For example, in theory, the grand plans of pointy heads, of the exquisitely educated politicians and bureaucrats who rule us, are more efficient than the messiness of us each going our own way. Yet that's not how it works out in practice. Similarly, there are many who insist that the price of something (say, rent, or food,) "ought" to be such and such in theory. But attempts to make reality accord with the prices fixed by that theory inevitably fail. Messily and with huge pain to all involved.

So worth keeping in mind what was possibly Hayek's greatest insight (not that he phrased it quite this way). When markets tell you that your theory is wrong it's the markets who are right and your theory which is wrong. This most especially applies to prices, for markets, not your theory, are what determine what prices are.