Some thoughts on rationality and economics, perhaps for a future paper, motivated by the financial panic:
Rationality is a property of equilibrium. By this I mean that
rationality is habitual and experience-based and it becomes effective
as it becomes embedded in the rules of thumb and collective wisdom of
market participants. Rules of thumb approximate rational decision
rules as market participants become familiar with an economic
environment. Individuals per se are not very rational; shift the
equilibrium enough so that the old rules of thumb no longer apply and
we are likely to see bubbles, manias, panics and crashes. Significant innovation is thus almost always going to come accompanied with a wave of irrationality. When we shift to a significant, new equilibrium rationality itself is
not strong enough to tie down behavior and unmoored by either reason or
experience individuals flail about liked naked apes – this is the realm of behavioral
economics. Given time, however, new rules of thumb evolve and
rationality once again rules but only until the next big innovation arrives.
Hi;
This is rather evident (I am certainly wrong) but it looks to me like cafe arguments…. I hope to read the paper soon.
Rgds
Could the rational/irrational be recast in terms of risk? It might provide a firmer foundation, as rational/irrational definitions get slippery fast: when is it rational to act irrationally? Meanwhile, a la Atwood, keep clapping if you believe in banks!
Given time, however, new rules of thumb evolve…
This rather implies that the ideally-rational outcome is also the evolutionarily stable outcome, something which is far from obviously true.
I like Randy’s “emotionality”, it makes a distinction that might need to be clarified: do you (Alex Tabarrok) mean that far frome equilibrium, people become unavoidably worse at making judgements, or that on top of the unavoidable part they also start to make “emotional” errors they could have forseen, such as selling in a panic?
I think David made an important point. Is there any a priori reason to believe that repeated, rule-of-thumb based habitus will eventually approximate to what we call rational behavior?
Hi Alex:
First, as Zamfir’s comment suggests, you need to define rationality. On a minimalist definition of rationality as transitivity at a single point in time, then a lot of apparently irrational behavior would be rational.
Second, your arguments are somewhat reminiscent of Doug North and Art Denzau’s claim that rationality is a social, rather than individual, concept (see their paper on shared mental models).
On the other hand, it is almost certainly true that individual rationality can be inculcated, at least to some extent, by raising the costs of irrational behavior. The implication of this is that institutional (including market) design might affect individuals’ responses to innovations, exogenous shocks (discontinuities), and shifting equilibria.
Finally, you seem to suggest that behavioral economics is concerned only with irrational behavior. I don’t think that’s true. It’s concerned with all human behavior, including the perfectly rational, the imperfectly rational, and the irrational (however we might define those terms).
Best.
Dan
Alex,
Interesting idea to work on. However, do note that Paul Heyne has long argued this point in his presentation of the principles of the economic way of thinking — see his discussion of rules of thumb and the question of cost plus mark-up pricing. I also think you can find similar discussions in Hayek, and his critique of “rational economic man”.
Personally, I think this is also what Vernon Smith argued in his discussion of ‘ecological rationality’ — at least that is how I have understood his argument. I think the major implication for economic theory is a switch from a focus on behavioral/cognitive assumptions to institutional context and the filter process that discipline decisions.
Let me be clear, I don’t think these previous works have settled the issue, I am just saying that you will have some important thinkers to build on who have laid out some of the groundwork for you.
Pete
P.S.: BTW, John List’s work might be added to the list.
This is why IHMO rules should be changed very slowly and carefully. Deregulation is mostly good but big changes in regulation can cause chaos in the short and medium time. It takes time for people to build systems to protect themselves. In the current financial crisis the market has finally lashed out and destroyed the more corrupt banks and with it much of the motivation to corruption; the worst thing to do now IMO is to make new regulations.
IMO this is also why interest rates should be changed slowly. A sharp drop can cause some chaos as we have seen.
I am a conservative libertarian.
(1) I agree that the word “rationality” here is a bit touchy, but I understand what you’re getting at. People act AS IF they are rational when using rules of thumb. Throw the system out of equilibrium and they can no longer behave AS IF they were rational, because the rules of thumb no longer work.
(2) I agree with Pete that several people have worked on this area before. I would add to Pete’s list some heterodox economists, such as my father (Edward Nell) and also agent based economists, in particular some econophysicists who have looked at financial markets, speculation, bubbles and crashes in this way.
(3) While you and my father seem to think that innovation can cause the upset, I personally think that some kind of regulation is more likely. When an innovation occurs you may have some herding effects, but I doubt you’d get a real upset. With innovation, you’re not likely to lose all your rules of thumb – just some specific categories of “whats good.” At first glance bubbles look like this kind of herding, with everyone jumping on the dot.com bandwagon, and maybe some are. But it also seems like you’d need more than an alluring investment opportunity to lose all rules of thumb — instead a new law or regulation or lending environment would seem to throw people off more.
I’m sorry, but that’s really an odd idea – that there was something irrational about the behavior that led up to this market crash. The reverse is true – it would have been totally IRrational for a home buyer/hedge fund manager/mortgage broker etc NOT to get on the band wagon. Imagine it’s 2004/5/6 – your neighbor/co-worker has just scored a good deal in a house or made a ton of money using complicated debt instruments – and the President is touting home ownership while the Fed Chairman is publicly totally confident in the ability of markets to regulate themselves …. you would be NUTS to turn away from doing what is so profitable to everyone else! (And if you were in ‘the business’, you would probably lose your job.)
The problem isn’t irrationality – it’s information, and timing. And although it’s unfortunate, there is only one kind of social organization that can help here (ie has the interest of the whole at heart, and can act on its information with proper timing) – and that’s government. I should add that the reason it’s unfortunate is that a significant portion of the electorate sneers at the whole ‘idea’ of government – which is bad for Dems and Reps alike. My answer: don’t demand LESS of government, demand MORE.
Analogy (yes, I know, analogies are in disfavor these days – but they work as long as they’re not tortured – hopefully this one isn’t): imagine the improvement in delivery times and lessened personal inconvenience if there were no automobile speed limits. It would be totally rational to go faster than you do today – in fact, because it is generally a bad idea to be going much slower than the average speed when traveling on a heavily used highway, it would be rational to speed up, like everyone else. But ‘we’ have made a judgment that the benefits aren’t worth the toll. Etc.
What’s irrational in my view, is to see what’s coming but do nothing about it. Here’s an excellent example: many many economists have been saying, for years, that the US is ‘living beyond its means’ – borrowing from China, not saving, running huge trade deficits, using gas guzzlers etc etc. So in many respects the current problems have been well foreseen. Yes, there have been some efforts to adjust but I would say they were at the margins. And granted, what was usually foreseen was a crash in the value of the dollar – which hasn’t happened. And maybe the current crisis will solve that problem too, by increasing the savings rate and lowering imports and driving the auto makers toward more efficient vehicles, etc. But the fact is, the existence of a huge problem has NOT been a secret.
MORE competence in government, not less! Let the parties compete on the basis of SMARTS, not …. what they currently do.
Oops …. that’s not too rational, is it?
I’m sorry, but that’s really an odd idea – that there was something irrational about the behavior that led up to this market crash. The reverse is true – it would have been totally IRrational for a home buyer/hedge fund manager/mortgage broker etc NOT to get on the band wagon. Imagine it’s 2004/5/6 – your neighbor/co-worker has just scored a good deal in a house or made a ton of money using complicated debt instruments – and the President is touting home ownership while the Fed Chairman is publicly totally confident in the ability of markets to regulate themselves …. you would be NUTS to turn away from doing what is so profitable to everyone else! (And if you were in ‘the business’, you would probably lose your job.)
The problem isn’t irrationality – it’s information, and timing. And although it’s unfortunate, there is only one kind of social organization that can help here (ie has the interest of the whole at heart, and can act on its information with proper timing) – and that’s government. I should add that the reason it’s unfortunate is that a significant portion of the electorate sneers at the whole ‘idea’ of government – which is bad for Dems and Reps alike. My answer: don’t demand LESS of government, demand MORE.
Analogy (yes, I know, analogies are in disfavor these days – but they work as long as they’re not tortured – hopefully this one isn’t): imagine the improvement in delivery times and lessened personal inconvenience if there were no automobile speed limits. It would be totally rational to go faster than you do today – in fact, because it is generally a bad idea to be going much slower than the average speed when traveling on a heavily used highway, it would be rational to speed up, like everyone else. But ‘we’ have made a judgment that the benefits aren’t worth the toll. Etc.
What’s irrational in my view, is to see what’s coming but do nothing about it. Here’s an excellent example: many many economists have been saying, for years, that the US is ‘living beyond its means’ – borrowing from China, not saving, running huge trade deficits, using gas guzzlers etc etc. So in many respects the current problems have been well foreseen. Yes, there have been some efforts to adjust but I would say they were at the margins. And granted, what was usually foreseen was a crash in the value of the dollar – which hasn’t happened. And maybe the current crisis will solve that problem too, by increasing the savings rate and lowering imports and driving the auto makers toward more efficient vehicles, etc. But the fact is, the existence of a huge problem has NOT been a secret.
MORE competence in government, not less! Let the parties compete on the basis of SMARTS, not …. what they currently do.
Oops …. that’s not too rational, is it?
ISn’t “foresight” more the word we are looking for than “rational”? In the sense that in a static environment, actors behave as if they have close to perfect foresight, at least in a probabilistic “risk” sense, while in fact they only use heuristic rules with limited applicability.
This can have two different implications: from a modelling point of view, it means that perfect foresight is a good approximation for the actors in a static environment but less so for dynamic environments, and from a behaviouristic POV it might mean that during a change, people will believe they still have good foresight and behave too risky.
FYI – I very definitely did not post my comment twice. I previewed twice – posted once. The software wants looking at.
Skip, my assumption was that Alex was talking about current behavior rather (i.e., liquidity preferences) than the behavior leading to the crash.
I think this is a nice concept, but it seems to neglect “everyday” irrationality of the kind that behavioral economics has gone over in some detail. For example, people’s investment behavior and studies of how sub-optimal it is. Maybe there’s a micro- and macro-irrationality?
Meh. Some notion of rationality is a prerequisite for equilibrium, that is, even defining what the equilibrium is requires a mapping from preferences to behaviors that meets some kind of rationality criterion. Unless you want to dig deep into learning algorithms, but even then, you’re still in bounded rationality territory, not a complete absence of rationality. I suspect there’s an equivocation on “rationality” here between the cognitive capacity to behave in a broadlhy preference-maximizing fashion and … something else, whatever that thing is that exists in equilibrium (people actually succeeding in preference maximization in fact).
With the conceptual stuff about rationality sorted out, this is sort of Herbert Simon, redux?
(Didn’t read the other comments, so sorry if this is a repeat.)
Very interesting thoughts.
If “rationality” is only a property of equilibrium, then what more general hypothesis about human behavior could describe both equilibrium and non-equilibrium behavior?
http://www.pnas.org/content/105/47/18153.full
The way I interpret you, “rationality” applies in the limit in which individual preferences are varying slowly with respect to supply. More generally, supply and demand may be mismatched in time in ways that tend to generate bubbles and crashes.
The guys who authored the linked article suggest that the exchange of email obeys non-homogeneous poisson statistics. It’s interesting that if one looks at a cumulative distribution function for a poisson distribution (within a window of time for a given group of people), it bears a strong resemblance to the aggregate supply curve from Econ 101.
I wonder: when did it actually happen? When did rationality rule?
To quote from Joseph Schumpeter, Theory of Economic Developmement (1912), p. 80:
“The assumption that conduct is prompt and rational is in all cases a fiction. But it proves to be sufficiently near to reality if things have time to hammer logic into men.”
In my opinion, more description of this selection process towards a long-run equilibrium is necessary to make a statement like “behavior that is guided by rules of thumb will eventually be rational because of a selection process that eliminates all but optimal heuristics”.
An interesting discussion of this Friedman-style selection argument was written by Jack Vromen (2005, ungated): http://www.eur.nl/fileadmin/ASSETS/fw/friedman.doc
A worthwhile topic, Alex_Tabarrok. This is similar to what was being discussed recently on overcomingbias.com, when Eliezer_Yudkowsky talked about how randomness helps algorithms (it doesn’t, except to the extent that keeps an adversary from finding enough regularity to extract information. As I put it, randomness is like poison: yes, it can help you, but only if someone *else* drinks it.)
One of his points was that you can only learn to the extent that the world has regularity. In a universe with random laws of physics, or otherwise near its heat death (very high entropy), learning is impossible because you cannot compress the data contained in your observations.
The implication for your research would be that a market where the rules (i.e. known regularities) stop applying, is approximating the high-entropy “unpredictable” universe. In such a universe the optimal stategy is to act randomly, since it will do just as well as any other strategy on average, but requires no effort (either in observation or computation) to figure out your next move. So, the further removed the market is from the past rules applying, the more rational it will be in the interim to act in ways that appear irrational or panicky.
Further thought: I think that part of the issue here is a confusion of information with rationality. People in pre-equilibrium states lack information which being in an equilibrium supplies, so their behavior (which is equally rational in terms of exercising cognitive functions that map preferences to choices) is less utility-maximizing.
This looks like an attempted partial refutation of the following: http://angrybear.blogspot.com/2009/01/what-i-really-think-about-finance.html
Or in other words, when significant innovation occurs, why don’t the ill-informed actors leave the market and better-informed ones enter?
Greg – you’re right. On reflection, I let my hobbyhorse carry me away – my comment was not appropriate to the subject. Thx.
Greg – you’re right. On reflection, I let my hobbyhorse carry me away – my comment was not appropriate to the subject. Thx.
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