Business Books: When rational market models go awry

By Richard Leong

NEW YORK, June 18 (Reuters) - The idea that markets behave rationally, which has dominated economic discourse for half a century, took a big hit in last year's credit crisis.

If markets were efficient, the argument goes, housing prices would not have grown into a bubble.

In reality, U.S. and European governments must now factor the vagaries of investor sentiment into their attempts at new regulations for financial markets.

Justin Fox, an economics columnist for Time Magazine, lays out these arguments in his book, "The Myth of the Rational Market" (Harper Business, $27.99).

The best known element of rational market theory is the efficient market hypothesis, which states that prices reflect all the known information about an asset.

Fox chronicles its rise at the University of Chicago in the 1960s, and its far-reaching impact on U.S. policies from setting interest rates to industry deregulation.

"I think in most cases the people who came up with the theories saw them for what they were, imperfect models of reality," Fox told Reuters. "But later on, some of them ended up being treated as eternal truths."

Fox's populates his book with both adherents of rational market theories, like Milton Friedman and Paul Samuelson, and detractors, such as Joseph Stiglitz and White House economic adviser Lawrence Summers.