Is a Rejection of Classical Finance Justified?

Einstein’s theory of relativity advanced Newtonian physics. That did not mean Newton was wrong – only that his theories could be improved upon. In an ambitious new book, the economist Andrew Smithers rejects core “Newtonian” principles of economics, replacing them with radical departures from conventional wisdom.

But as I will explain, unlike Einstein, some of Smithers’ theories fail meet the standard of empirical verification.

Looking at the world from a different angle

Sometime in the early 1970s, the comedy troupe Firesign Theater recorded an album called “Everything You Know is Wrong.” It was a satire on “new age” thinking: Dogs flew spaceships! The Aztecs invented the vacation! Men and women are the same sex! Aliens are living like Indians in an Arizona nudist park.

You get the idea.

Smithers’s new book, The Economics of the Stock Market, presents bold and provocative theories that advance our understanding of financial theory. But there are moments that are reminiscent of Firesign Theater – at the extreme, leading one to believe that everything one knows about the stock market is wrong. Here’s Smithers channeling Firesign:

  • The expected real equity return is stable, at 6.7%, no matter what is going on in the bond market.
  • The risks of equities “fall sharply as the time horizon lengthens.”
  • Bond yields fluctuate “within narrow ranges.”
  • Companies don’t try to maximize profits.

It's easy to dismiss these sweeping statements that contradict our understanding of markets. But it’s not easy to argue with a man who “in 1956… went up to Clare College Cambridge to read economics,” and who has been thinking about economic principles and putting them into practice for more than 60 years. Smithers is eminently qualified to question the tenets of neoclassical economics as it has been applied to finance in those 60 years, and he does so in an exemplary way: no math, crystal-clear writing, and a rich vein of data graphics.