Myth of the rational market

Conor Clarke observes that in Animal Spirits George A. Akerlof & Robert J. Shiller point to the popularity of Texas hold 'em as symptomatic of the speculative fever of the past decade. I've been reading a fair amount of financial history from the late 1990s and early 2000s. Skeptics of Shiller's arguments during that period fairly depict his theses as a mishmash of post hoc ergo propter hoc. The problem is evident all through Irrational Exuberance, the book which made him the Cassandra of the age along with Nouriel Roubini. But though on the specific causal factors adduced I remain skeptical, in the generality I do think behavioral economic critics of constructs such as the efficient-market hypothesis are right. In The Myth of the Rational Voter Bryan Caplan lays out the case that democratic majoritarianism is often irrational in maximizing utility because not only are voters stupid in the aggregate, but their stupidity exhibits systematic biases. If their stupidity was randomly distributed then of course it would "cancel out" and the rational signal would be determinative of decision-making, but aggregate biases derived from the nature of human cognitive hardware can easily be the most powerful directive.

This is a world of irrationality, where reason is the slave of the passions. Those who argue for the power of the market due to its rationality, derived from the aggregate choices of individuals, need to confront this reality. That being said, those who argue for the rationality of economic planning through a centralized decision making structure have to confront the same realities (and also the track record of "natural experiments" in the command economy). I come not to bring peace of mind, but to bring a sword of uncertainty and avarice.

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(I defy anyone to justify keeping these histories little-apparent -- as serving the common good!)

Asset price bubbles are surely the enemy of the people.
Such bubbles are well-shown by real inflation-corrected price histories, e.g.
âReal Dow & Real Homes & Personal Saving & Debt Burdenâ at
http://homepage.mac.com/ttsmyf/RD_RJShomes_PSav.html
Well-shown dictates well-deterred -- thatâs clear to me.
But these histories are kept little-apparent -- because more money is made from bubbles by those who provide information flow to the people.
In fact, all four of the extremes in the above title beget more paid advertising -- to feed the news media who keep the histories little-apparent.

I come not to bring peace of mind, but to bring a sword of uncertainty and avarice.

Somehow I find that comforting. Can't figure why, but it explains why economics are so hard to understand.

Reversion to the mean explains a lot about investing, not just about genetics.

By bioIgnoramus (not verified) on 08 Feb 2009 #permalink

What is most bothersome is that so many economists seem to fully believe that know the answers and anyone who disagrees with them is an idiot worthy or ridicule. I'm no economist but I've tried to look through the evidence for both skeptics and defenders of the current common wisdom. As best I can see there's not a whole hell of a lot of evidence. To treat this as perfectly rational rather than what it is - a bet - seems amazing to me.

We saw no end to hubris the past 8 years. After being pretty pleasantly surprised this fall with how Obama was starting things I've been massively disappointed with how the past couple of weeks have gone.

. I'm no economist but I've tried to look through the evidence for both skeptics and defenders of the current common wisdom.

yes, but do note that there were economists (e.g., shiller) who warned about what was going on. it wasn't the whole profession, which is much more diverse than financial economics. even within finance there were people who were skeptical. but the point is that enough people decided to go hogwild on leverage and risky bets that the system has had a meltdown. people get to keep the money they make, but if they don't have the money to cover their liabilities, what are you going to do? we don't have debtor's prisons. the system lacks balance in that way. perhaps if you lose enough money you should be executed? the main problem that i see is that the upside (making gajillian dollars) is just way bigger + than the downside (going bankrupt) is -, so you're incentivized to take big risks. killing someone might be the best way make sure that people own up to their billion dollar losses (or perhaps executing the whole extended family chinese style?).

Yes, although some people were perhaps coincidentally right (perhaps Roubini as DeLong notes) and others were looking at other reasons. I had a meeting with a billionaire hedge fund operator who got out of the market last spring because he thought greed has warped everyones head such that the unpredictabiltiy was simply far too high. He did quite well since he got out months before the crashing started. One of his clients didn't want to and lost a billion dollars in August alone. Was this guy theoretically correct though just because he saw there was problem?

I think one can see that knowledge is low and that there is thus a problem without having positive knowledge of what is going on. A subtle but important distinction.

My point is that right now economists (or at least some economists) are making positive knowledge claims where the evidence seems to significantly undetermine their claims. Don't get me wrong. I'm willing to try Keynes if only because no one else appears to have a better plan. Plus, as skeptical as I am of the "let us try and all you Republicans screwed it up" idea there is something to the "Obama won" meme.

So my opposition is more to the false claims of knowledge than real strong opposition to the plans of Obama.

we don't have debtor's prisons. the system lacks balance in that way. perhaps if you lose enough money you should be executed?

I've long advocated bringing back a form of judicial-imposed slavery or indentured servitude for identity thieves and the computer programmers who make viruses to get your info since these two groups can: wreck your credit, steal your money and ruin your life. I think I'll put bad financiers on that list since, although they aren't meaning to do what the ID thieves do, they can still do all the three things I listed above.

numbers matter. if it is a hacker who unleashes an internet worm or something which swallows up weeks of labor from thousands of people, and causes major macroeconomic distress, why not gauge their eyes out, tear their eardrums & tongues out, and leave them alive? it seems quantitative impact should figure into this. if someone causes liabilities to be incurred on businesses on the order of *billions* of dollars (this has happened several times) through reckless behavior, why should they live? are they any better than bernie?

i think we live in an age where moral hazard is rife. huge piles of capital hinge on the decisions of individuals. if the individuals lose it all, and leave a trail of debt, you can't magically squeeze the destroyed value back out of them. on the other hand, if they luck out and get huge returns they keep their winnings. the partners of long term capital management, which had to be bailed out on the order of $4 billion dollars, managed to negotiate salaries of $500,000 a year, and ended up starting a new hedge fund 2 years later. they lost it all, but they are left with much.

Also remember that economists don't run the economy, nor the government. Whoever is in charge can always find a few economists to sign off on whatever crazy scheme they want to try.

Now we have Obama and his dinosaurian kook economists. I thought they were about extinct, but let the left come back to power and suddenly they are crawling all over the place.

Bush was simply another big-government type, not so different from any Democrat you can name, on domestic issues. Spend big, borrow big.

Be nice to at least try something different.

The real difficulty of the idealization of the "rational market" is the assumption of "perfect information". This is not merely assuming a spherical cow, but a spherical cube. Information is a resource - arguably, THE resource. Inference/analysis of information to made inferences and decisions requires resources. Economics treats the cost of the resources involved as zero.

Pretty much every major lunacy in Economics tracks back to this. (The exception is the Randite concept of property as an absolute, which is an error resulting from Rand's handwaving over the meaning of "rights" and inability to handle logics with more nuance than purely binary YES/NO.)

I would lean towards a bias that indicates it is possible to formulate a "rational market" both as an advantage and as a religion.
We no longer live in an age of reason. We live in an age of manipulation of belief systems by incredibly wealthy and powerful individuals and organizations.
The old sales saw that if you state a lie often enough it becomes a truth is the currency used today. I don't believe our founding fathers would have looked kindly at the rampant economic manipulation we find in our markets and those who report on them.
Further, ignorance is no longer bliss. Large corporations and goverments use "sound bites" as ersatz knowledge which becomes either religious in nature or heresy to intelligent people. Since religion is considered to be the focus of our founding fathers, it is almost inevitable that those who see the fallacious sound bites for what they are become heretics to the masses.
Evolution favors the genetic material which best directs the organism to suceed reproductively. Today we have the amazing contradiction of less education, more children. This turns evolution on its ear. Unfortunately this same tendency creates a world in which the stupid are controlled by those who promote the biggest lie: rational market theory.

By david bower (not verified) on 25 Aug 2009 #permalink