Many critics have deservedly praised the new docudrama about the 2008 financial crisis, The Big Short. Unfortunately, movie critics seldom understand finance so few reviews comment on the investment implications that the film raises. With the stock market crashing early in 2016, it is important to consider what this film reminds us about the lessons of 2008.
The No. 1 lesson is that we do not have a market economy. We have an economy that includes some markets, but, contrary to the assumptions of textbook finance and economics, most important business transactions are not pure market transactions, but negotiated deals and strategic plays. These may affect markets and may reference markets, but they are not themselves pure market phenomena nor the “random walks” of mathematical finance theory; they are strategic acts infused with private power and intent.
In order to understand the modern business system, it is necessary to study not economics or finance, but political economy. I lay out the agenda for such study in my blog and my book, International Political Economy: The Business of War and Peace. Political economy elevates the study of private power and strategy to the core rather than the neglected periphery of economics.
Finance theory is the study of markets when nothing much is happening, during routine times — using what Chinese strategist Sun Tzu would call the “ordinary method.” Whenever any asset is, according to Wall Street argot, “in play,” then the “extraordinary” or strategic method is required to analyze the consequent interactions. This method is taught in my book and blogs, but not in economics or finance courses.
The film is a selective retelling of Michael Lewis’s best-selling book, The Big Short. Both center on a small group of investment fund contrarians and misfits who discerned the real estate bubble when others were still being misled by the bullish hype so prevalent in the media and official circles. They found ways to short the market — to bet that asset prices would fall, aided by big banks that developed new credit default swaps (CDS) to insure mortgage-backed securities (MBS) against default.
Originally published at The Street on January 13, 2016 – Will ‘The Big Short’ Help Us Learn the Lessons of the 2008 Financial Crisis?