A recent column by Dan Arielly gives me a reason to discuss what I think are some of the problems with the recent emphasis on irrationality in economic theory. Before I get into that, I should note that I liked Arielly’s book Predictably Irrational, and am impressed by Shiller’s work. The idea that people behave non-optimally regarding economics–that is, we are not perfect economic calculators–is very important. For instance, understanding economic bubbles doesn’t really make sense unless one accounts for irrationality (e.g., Shiller’s work). Likewise, Arielly’s Predictably Irrational does a wonderful job of examining how the cognitive shortcuts and heuristics that people use can lead us to make stupid choices. My own personal example is when I saw two people at a drug store buy a 200 count bottle of Tylenol ON SALE!!! FOR ONLY $12, when the 100 count bottle of Tylenol cost five dollars. Clearly, the ‘Ooh! Shiny Pebble!’ response (among many other cognitive phenomena) is something economists need to understand.
Related to this, a behavioral ecologist I knew, when asked about optimal foraging theory (which assumes that animals are perfect estimators when maximing caloric and nutrient intake) used to say, “I don’t believe in optimal forgaging theory. But pretty good foraging theory, I’m ok with.” The deviations from optimality are very revealing. But I think too many different phenomena are huddling under the banner of ‘irrationality.’
When Arielly and Shiller describe how people, trying to achieve one outcome, end up accomplishing the opposite due to biased human cognitive processes (“Shiny Pebble!”), that to me qualifies as cases of irrationality*. But here’s a list of ways I think irrationality is misused (not by Arielly or Shiller, mind you):
- Acting on incomplete or bad information is not irrational. At the risk of channeling my Inner Jeff Foxworthy, it might mean that you’re fucking ignorant. Or not. Lots of people are very knowledgeable about some things, whether it be motorcycle repair or multivariate statistics. But imagine they’re told by a banker, “Sure you can afford this ARM loan. You’ll just refinance, and be fine, because housing prices always rise.” Then imagine that there are quite a few news sources, pundits, and so on echoing these sentiments. (Mind you, this is purely a hypothetical scenario). If you don’t know much about the history of housing prices–a rather esoteric subject–it’s not irrational to take out the ARM loan.
- Engaging in a bubble economy isn’t irrational. Yes, Shiller has convincingly demonstrated that irrational behavior can lead to bubbles–and that many people are powerless to resist them. But if you believed there was a housing bubble in early 2001 (or a tech bubble in the mid-90s, or….), then getting in early and leaving before the bubble collapses isn’t irrational. You are engaging an irrational system, but you’re not irrational. And if you’re aware that the music might stop, and you could be left without a chair, that, to me, seems to be an acceptable, rational understanding of risk (as long as you can cover your losses).
- Focusing on short-term interest is not irrational. If your long-term goals are more important to you, then, yes, you could be behaving irrationally. But if you have made your short-term goals (‘live fast, die young’) your first priority, then short term interests are not necessarily irrational. They may be more aggravation than they’re worth, but that’s a separate issue.
- A lack of concern for the public welfare is not irrational in some circumstances. It might be dishonorable, unethical, and all around shitty, but it’s not necessarily irrational. Consider finding a wallet with some credit cards and $100. You’ll probably return it, if for no other reason that $100 isn’t worth shredding the social compact. Given the hassle of having to replace credit cards, licenses, and so, most people would appreciate someone else returning a lost wallet. Now imagine you find a wallet with a cashier’s check made out to “Cash” for $10 million. I would like to think that I would return it because it’s the right thing to do. But it’s a lot of money. Is the cost of shredding the social compact worth $10 million? While I think “yes” is a bad answer, I can’t call it irrational.
- Particular ideologies, while they can be stupid and disconsonant between their stated goals and results, are not necessarily irrational. Various ideologies are often used (at least initially and in moderate doses) to justify outcomes that are beneficial to those who believe in the ideology. They also serve a role in rationalizing away cognitive dissonance (again, there is a difference between unethical and irrational).
Before the end, I want to leave you with an observation by reporter Paul Solman. Solman recounts an interview with NY Times journalist Ed Andrews about the response to Andrews’ story recounting his own bankruptcy:
I was quite sympathetic, I guess, to an answer of his that didn’t make it into our NewsHour story. It came when I pressed the question, “How could you have fallen for it?”
“I didn’t fall for it. I knew this was a huge gamble from the moment I took it on, but a house is the kind of thing that grabs a hold of you in so many different ways. It was absolutely the critical link for my kids to have the stability and continuity as I tried to start the second chapter of my life. It was crucial to having our families be able to come together, and we had a lot of children between the two of us. If it was just Patty and me we wouldn’t have gone down this road. We had a boatload, a Brady-bunch load of kids between us and so you know this was the part that could make the dream come true and I had my own dream here.”
This hardly gets him off the hook. But then, he said he was guilty as sin, only no more so than many people around him.
And before you consider Andrews to be behaving irrationally by taking a huge risk with his debt load, consider this astute comment by economist Brad DeLong:
So Ed Andrews’s adventures in real estate have lost him $46K in NYT stock that he sold to make his down payment–stock that would now be worth $14K…
He has now lived rent-free for the ten months since be stopped paying his mortgage–call that +$32K…
He paid essentially a market rent for the house via his mortgage payment but he got a tax shield worth $500 a month for 42 months–+$21K…
And he pumped $58K out in his home equity loan…
So by my count his adventure in real estate has enabled him and his wife to spend $97K more over the past five years and still arrive at the same asset position as if they had rented…
Maybe those of us who didn’t play the recent mortgage market were the irrational ones…
* Defining irrational is not a trivial matter. If if one were to define it as the inverse of rational activities, it’s not clear how one does that.