Music to My Ears

by Will Wilkinson on September 24, 2009

Roman Frydman and Michael Goldberg at the FT’s Economist’s Forum:

Behavioural economists have uncovered much evidence that market participants do not act like conventional economists would predict “rational individuals” to act. But, instead of jettisoning the bogus standard of rationality underlying those predictions, behavioral economists have clung to it. They interpret their empirical findings to mean that many market participants are irrational, prone to emotion, or ignore economic fundamentals for other reasons. Once these individuals dominate the “rational” participants, they push asset prices away from their “true” fundamental values.

I’ve been harping on this error for years, but it has seemed to me that economists generally don’t grok what the error is. It’s good to see economists who get it.

Mr. Econotarian

The challenge is that government is just as likely, if not more likely, to act irrationally than market participants.

While large banks were mis-reading CDO risk, government was funding no-money-down loans through the FHA, extending an implicit backstop to Fannie and Freddie, and trumpeting how good it was that homeownership levels were so high.

Is it truly likely that a government entity will have a more accurate viewpoint on an economic situation than the majority of market participants?

I think it is likely that government regulation is useful for correcting the few outliers in terms of risk, but is unlikely to be ahead of the majority of market participants.

If government was ahead of participants, they could simply quit the government and take an opposite market position and make lots of $$$

sam

A little Pascal might have given pause to the rational action theorists in economy. You know, the bit where he says:

"The heart has reasons that reason cannot know."

Oh, and a close reading of any great novelist would be salutary. Or reflection on a busted love affair.

Aaron

I'm taking a behavioral finance class this semester, and just read the article on Prospect theory by Kahneman and Tversky. It's interesting that they didn't call the decisions being made that contradicted utility theory as being necessarily irrational. They certainly saw problems with how people figured odds, but it isn't necessarily irrational to be more adverse to loss vs. gain, as they described in their article.

Tremulous

The Tversky-Kahneman results allow people to be money pumped. They will pay to move from state A to state B, pay to move from B to C, and pay to move from C to A. Regardless of definitions this is certainly irrational.

simonkinahan

I couldn't get past the horrible misrepresentation of the rational expectations hypothesis. Are you sure these people are actually economists?

j r

this same observation can be extended beyond economic policy. there is no end to those who agitate for changes in public policy based on the idea that they know the "reasonable" amount of secondhand smoke, trans fat, coca cola, bandwith, MRIs, etc... that each person "ought" to have.

if for a moment, however, we allow for the possibility that we all have different indifference curves and value all these things at different levels, then, as frydman and goldberg state, it might, "require policymakers to exercise discretion, rather than simply rely on fixed rules."

of course, those with the most powerful voices in the public policy process like having fixed rules. it allows them to better plan their strategies and allocate their resources most efficiently. perhaps the rational operation of the political market will forever be an obstacle the the rational operations of all other markets.