Rational Markets - Are they doomed?

Robert Peston's excellent Blog on the BBC here >> talks about rational behaviour in markets, and reports:

Hector Sants, the chief executive of the Financial Services Authority, has delivered two thoughtful speeches in the past couple of days, in advance of the City watchdog's publication next week of its initial proposals on reforming the "structural regulatory architecture".

For me, the most striking assertion by Sants was this: "Markets have shown not to be rational; excesses have not been corrected by market discipline".

I think the issue here is that the rational thing to do in any market is to act irrationally at times.

The winners in a rising market sell just before the top if the market, for example, and with hindsight that behaviour looks rational, but to those around them at the time is clearly irrational. In fact their irrational action perhaps triggers other action that is itself irrational, but progressively makes the action itself look more and more rational.

Looking back now the situation in financial markets was clearly unsustainable, yet when it was being viewed without hindsight there was no reason to suppose that it was about to change, except that - that was the rational view that most people held - that itself should have been a warning perhaps.

Rationally, transferring governance to an independent body or bodies (the FSA and BoE) was a rational thing to do, and came just a few months after the Independent Insurance company failed. "It'll not happen again" we were told. This was an insurance company that failed through all of the same things that have happened since.

Irrationally the right thing to do now is to stop bailing things out and ride the consequences. I still think one major player in every global market will fail before we can come through this. The reduced capacity and changes in behaviour will stabilise the markets (but - once stabilised the irrational thing to do is to destabilise them). However, if the rational thing to do is irrational, then irrationality becomes rational.

It's a version of catch 22, rationally....

Tagged as: BoE, Finance, FSA, Hector Sants, Markets, Robert Peston