Friday, December 16, 2005

Economics of unreason

It is always amusing to see the market economy characterized as a rational process. Of all adjectives. Of course, I can understand this on the individual level, but since when has individual short term rationality (we almost all are individually and in the short term rational within our own varyingly eccentric perceptions and definitions of rational behaviour), but since when has this translated into reason on any collective level?

The thing that keeps the bubblenomics that is the American economy going at the moment, is the irrational trust in it. By now this trust has been going on for so long (about 3-4 years) that already the first voices are being heard to say that this will go on for ever, that this is now the "new economics" and the old rules are no longer in force. Which is the surest of signs that the bubble is about to burst. And burst it will: American private and public deficit financing can't continue for ever. The trust will turn out to be brittle and the longer the grim reality is referred the more painful the adjustment will be. For all the world. This time things might actually get very nasty indeed. If only we would be able to operate a rational economy... (Which we obviously aren't for a very long time to come.)


helsinkian said...

Rationality is just an illusion in economics. I'm a huge believer in the irrationality of the economic animal. Irrational choice. That doesn't have to be a bad choice but the choice of the consumer is not usually based on reason. We're gullible, emotional and unstable - sometimes even downright crazy.

There are millions of factors that seal business deals and only some of them are rational. I'm not even sure that the rational self-interest is good for the majority. Even if all of my decisions would be completly rational from my viewpoint, somebody else would probably get screwed and get some irrational feelings about it.

Anonymous said...

Rationality in economics, in my mind, is the cornerstone of it all unless one believes, for instance, that one can manage a successful business by selling the products at the lower prices than one bought/manufactured them. Rationality, however, seem to have left "the good ship" USA even if the administration is occupied by the party which is usually known, by many, of its' superior handling of trade and budget issues.

What has taken place in the recent years has increasingly taken the breath away among the onlookers on the inside of the US as well as on the outside. Let me throw some numbers at you; the national debt stands at $8 trillion ( how many zeros is that? ) which amounts to more than $27 000 per capita and the federal budget deficit is $314 billion. While all this is happening, the the average American, busy as a beaver consuming and doing it with ever increasing credit, has forgotten the meaning of the word to save. Now, according to their incomprehensible logic the Bush administration has successfully pushed through a new tax cut which gives to the richest of them all an average of $19 000 in reduction. You must earn more than $1 million to qualify for it. If you are in a income bracket of between $100 000 and $ 200 000 it is only good for one visit with the family to McDonalds, in other words $25. Those earning less than $100 000; you aint' gonna get nuttin. I don't deny that some kind of trickle down effect and thus economic stimulus is possible but, surely, it will be for a very short term. I also fear that the funds are coming from the slashed social programmes and therefore amounting to stealing from the poor and giving it to the rich. It is painfully clear that rationality is running oh so low in the White House.

I am afraid that I have come to a point where I leave my own rationality behind and say that the collapse might not be imminent. Predictions about the US going down to tubes, and there have been many in the past, have so far been premature and each and every time she has pulled herself out of the abyss. There is no denying, the fundamentals are really bad and as insane as the things look right now I am still willing to predict, based on her huge intellectual capacity, that she will somehow do it once again. The alternative would be too horrible to contemplate.

stockholm slender said...

I would put it that people usually behave rationally meaning that their behaviour is not erratic, random, unpredictable or inexplicable. But they define reason in a myriad of ways that are largely culturally determined. And it is very hard to construct any "natural" hierarchy of rationality. So, reason is relative - one of the ways to measure the degree of rationality of the various schools of thought is to check whether they admit this relativity. It is irrational to think that only my way of thinking and valuing is rational and that all other evaluations and approaches are irrational.

The US economy is simply scary: the longer this insane party goes on the worse the crash will be. It might be very disastrous for the whole world economy. Interesting times...

helsinkian said...

What is rational to one person is not rational to another. The US government does not behave in a responsible way since they are out to please the voting public. They believe that the voters hate taxes but love spending. That explains a lot of what they're doing - they're not behaving so rationally from an economic point of view but they're behaving rationally from a short term political point of view. Now I believe in government as a responsible economic actor and I certainly think the US government was working when President Clinton was working together with the Republican Congress.

But I don't believe in private actors behaving in a rational way or at least they're not always playing by the rules. Companies like Enron and WorldCom undid many people's rational plans by cheating and getting caught and shaking the belief of the general public in the rational behavior of markets.

Esaijas Ranstakka said...

"Mummy, mummy, look, I'm behaving irrationally!" Buddy Bug in L. Carroll: Alice in Wonderland

The irrationality of market

Journalists often describe stock exchange as it would be (wounded) animal. It is nervous, impatient or calm. Within the turbulence, a central bank has to act as a lion tamer.
During the last three decades, Eugenio Fama's hypothesis of efficient market has kept financial economists occupied. It simply say that all relevant information immediately affect stock prices. There is no information which open up us better possibilities to forecast the future development of stock price better than present price. Although there are suprisingly lot of empirical evidence for that hypothesis, its seem to be one example of economic theories, which leave all interesting questions outside.
Some schools have tried to explain the behavior of markets and investors psychologically. The results of these attempts has left quite stray, because it is reasonable difficult to create theory that systematically can reduce stock market behavior to psychology. The herd behavior take effect on investors but it is difficult to say when, and when expectation are rational.

The irrationality of consumers

The customary economic theory assumes that a rational consumer maximizes her present and future utility using information which she has. It assumes that people assess their future like you, Stock, based on probabilities. Von Neumann-Morgenstern's utilities are formed by the expected value of future utilities, which mean in the simplest case that different possible ulilities are multiplied by their probabilities (in more complex cases, we are interested in other moments of variables, like variance, also). It is funny to ponder how well this kind of formulation and people behavior matches, when they are buying house, getting married or changing employer.
Anyway, we can ask how rational are the expectations of American consumer, who borrow money and spend and spend.
Stock, things change. As stupid as to say that we would have reached the era of everlasting stable economic growth, it would be to say that the world is same than at Keynes's time.
The different economies in the whole globe are connected to each others, but for example stock markets do nowhere near perfectly correlate. For example, the stock markets indexes of emerging economies are more correlated to US's interests market than to stock market. I'm not wise enough to say how business cycles fluctuations will develope. Maybe, US's domestic markets are not so crucial for example for Finland as before.
Classical and neoclassic (as well Keynesian) theory expresses that the amount of investements basically depend on savings. Nowadays, this connection is quite difficult to see. The amount of international investment capital has drastically increased. Of course, this has an impact on the households' and companies' capability to manage deficit. From historical standpoint US's public finance seem to emerge from deficit easier than European countries.

stockholm slender said...

Very interesting points - though much beyond me, I'm afraid. I would guess that our experience is continuously unique, though certain mechanisms of economics are durable. So who can say. Well, Keynes famously said that in the long term we are all dead. There is great wisdom in that statement: it encourages as for pragamatism and for reacting to changing circumstances. I'm think that is something that we are not doing currently: cheerfully gliding towards a great collision...