PSA: The market isn't always perfect. Economic actors are not always rational.

[yllus]

I've seen this debate be brought up once in a while on these forums, and browsing The Week a couple of days ago I read an editorial by Brad DeLong that touched on the topic. With a new book entitled A Failure of Capitalism: The Crisis of '08 and the Descent into Depression by Judge Richard A. Posner, it seems like this topic can begin to be addressed in depth.

Hypothesis: Markets are perfect. Actors in that market will act rationally to maximize their profits and avoid losses.

Below, Mr. DeLong lists a number of examples of actor irrationality, and quotes an extremely prominent member of the Chicago School of Economics implying that strong government intervention is sometimes needed to correct irrational actions.

The Chicago School is eclipsed

Richard Posner, leader of the Chicago School of Economics and Fourth Circuit Court of Appeals judge, uses his new book, ?A Failure of Capitalism,? to try to rescue the Chicago School?s foundational assumption that the economy behaves as if all economic agents and actors are rational, far-sighted calculators.

In some sense, Posner must try. For without this underlying assumption, the clock strikes midnight, the stately brougham of Chicago economic theory turns into a pumpkin, and the analytical horses that have pulled it so far over the past half- century turn back into little white mice.

Thus he writes: "At no stage need irrationality" on the part of markets or their participants "be posited to explain? the collapse of financial markets last year and the current deep recession.

We see many things in the financial crisis and the recession that are not what we would see in an economy populated by smoothly rational utilitarian calculators:

* It was not rational for Bear-Stearns CEO James Cayne, with his own $1 billion fortune on the line, to allow his firm to become hostage to the excessive risks taken by his subordinates in the mortgage markets.

* It was not rational for Citigroup CEO Charles Prince to keep dancing to the music, without thinking which seat Citi would claim when the round of musical chairs came abruptly to a halt.

* It was not rational for shareholders of newly incorporated investment banks to offer traders large annual bonuses for performance assessed by a year-to-year mark-to-market yardstick?rather than rewarding them with long-run restricted stock that would hold its value only if the traders' portfolio strategies proved durable.

* It was not rational for the shareholders and executives of General Motors and Chrysler to ignore the need for a Plan B in the event Americans fell out of love with SUVs.

Yet while Posner insists on saving the appearance of individual rationality, he is willing to jettison the Chicago School's conclusion that markets are everywhere and always perfect. As Robert Solow observed: "If I had written that, it would not be news. From Richard Posner, it is."

Abandoning the conclusion of market perfection opens the door to the idea that government needs to properly check, balance, and regulate markets in order to help them function as well as possible. But clinging to the assumption of individual rationality forces Posner?s view of what regulation is appropriate into a very awkward straightjacket.

"The mistakes were systemic,? he writes, ?the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools." What we needed, Posner implies, was a Daddy State in the early 2000s that would have kept interest rates high, kept the recovery from the 2001 recession much weaker, and kept unemployment much higher.

The Daddy State should have restricted financial innovation because a "depression is too remote an event to influence business behavior. "The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy."

Posner's claim that the Princes of Wall Street were rationally ignoring small probabilities is simply not true. The venture capitalists of Silicon Valley in the 1990s raised money for their funds overwhelmingly through equity rather than debt tranches.

They did so because they wanted themselves and their clients to retain some considerable fraction of their fortunes in an event that they regarded as small probability?but actually happened?that the overwhelming bulk of the value from the internet revolution flowed to customers rather than to businesses.

Explanation: Book reviewer Jonathan Rauch of the New York Times summarizes:

Populists and libertarians will hate this book, though I wouldn?t want to predict which group will hate it more. A perfect storm of irresponsibility? Hardly. The crisis came about precisely because intelligent businesses and consumers followed market signals. ?The mistakes were systemic ? the product of the nature of the banking business in an environment shaped by low interest rates and deregulation rather than the antics of crooks and fools.?

Were a lot of people reckless and stupid? Of course! But that cannot explain why the whole system crashed, since a lot of people are always reckless and stupid. The problem, fundamentally, is that markets cannot, and rationally should not, anticipate their own collapse. ?A depression is too remote an event to influence business behavior.?

Any single business can rationally guard against its own bankruptcy, but not the simultaneous bankruptcy of everybody else. ?The ­profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy.?

And so ? here is the part libertarians will hate ? markets, entirely of their own accord, will sometimes capsize and be unable to right themselves completely for years at a stretch. (See: Japan, ?lost decade? of.) Nor can monetary policy be counted on to counteract markets? tippy tendencies, as so many economists had come to believe.

Alas, economists and policy makers got cocksure. They thought they had consigned depressions to history. As a result, they missed warning signs and failed to prepare for the worst. ?We are learning,? Posner writes, ?that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.?

So what say ye? I can see substance in the opinion that a businessman will guard against his own losses but care little for taking actions that spare others - even though enough losses by others will lead to his own. Logically following that line of thought, an actor with significant market heft may be needed to take the longview and be afforded more tools than what the Federal Reserve currently has.

 

[StageLeft]

Uncertainly people are not rational. This is easy to see in a market that can drop or gain based on hysteria and no real data. Intervention definitely has its place.

 

[racolvin]

I would say that if each individual businessman were to guard against his own losses appropriately, then nobody would go bankrupt and that would be dandy. However, that wasn't the case. Many "businessmen", Wall Streeters, seemed to have behaved in the mindset of "I'll take these huge risks and assume that nobody else is, that way if I go bust its just me that gets hurt and not anyone else". Problem is, many of them thought that way and they did it with big bucks, so that when then all took a crap they looked around and said "hey, you weren't supposed to be doing that while I was, now we're both in trouble!" - except that there were many more than two parties involved.

 

[Phokus]

It's obvious people are not always rational actors, you can find numerous instances of this. For example: people will sometimes avoid preventative healthcare to save on short term costs, but pay dearly for it in the long term. Only idiot 'true believers' in the free market believe people are rational actors 100% of the time.

 

[Jaskalas]

Originally posted by: Phokus
It's obvious people are not always rational actors, you can find numerous instances of this. For example: people will sometimes avoid preventative healthcare to save on short term costs, but pay dearly for it in the long term. Only idiot 'true believers' in the free market believe people are rational actors 100% of the time.

Your argument sounds like people should be governed and micro managed. An anti-thesis to individual liberty and freedom. Is that what you truly stand for?

We digress. The argument of free markets is not about rationality. This is a subject about ownership and control. It is about power. Who should hold this power, the peasants or their lords? Apparently you think the peasants make mistakes, so to strive for perfection this power should be taken out of their hands. I disagree, perfection is not what we should strive for at the sacrifice of liberty.

I would rather live freely in an imperfect world than in a perfect cage.

 

[n yusef]

Originally posted by: Jaskalas

Originally posted by: Phokus
It's obvious people are not always rational actors, you can find numerous instances of this. For example: people will sometimes avoid preventative healthcare to save on short term costs, but pay dearly for it in the long term. Only idiot 'true believers' in the free market believe people are rational actors 100% of the time.

Your argument sounds like people should be governed and micro managed. An anti-thesis to individual liberty and freedom. Is that what you truly stand for?

We digress. The argument of free markets is not about rationality. This is a subject about ownership and control. It is about power. Who should hold this power, the peasants or their lords? Apparently you think the peasants make mistakes, so to strive for perfection this power should be taken out of their hands. I disagree, perfection is not what we should strive for at the sacrifice of liberty.

I would rather live freely in an imperfect world than in a perfect cage.

o.o Jaskalas is secretly a communist?

 

[Craig234]

The 'rational market' is an ideology that causes great harm for its imperfections and inacccuracies. Naocmi Klein's "The Shock Doctrine" should be read by anyone who wants to comment on the Chicago School of Economics' ideology.

 

[Phokus]

Originally posted by: Jaskalas

Originally posted by: Phokus
It's obvious people are not always rational actors, you can find numerous instances of this. For example: people will sometimes avoid preventative healthcare to save on short term costs, but pay dearly for it in the long term. Only idiot 'true believers' in the free market believe people are rational actors 100% of the time.

Your argument sounds like people should be governed and micro managed. An anti-thesis to individual liberty and freedom. Is that what you truly stand for?

We digress. The argument of free markets is not about rationality. This is a subject about ownership and control. It is about power. Who should hold this power, the peasants or their lords? Apparently you think the peasants make mistakes, so to strive for perfection this power should be taken out of their hands. I disagree, perfection is not what we should strive for at the sacrifice of liberty.

I would rather live freely in an imperfect world than in a perfect cage.

1) Of course that's a straw man argument, i never said such things. I say let the free market be when it doesn't harm anyone, and regulate it when there's a market failure or big potential for one.

2) of course it is about rationality, you free marketers always say, 'i know what to do with my money better than the gubmit! blah blah blah'.

3) Sometimes it's because peasants make mistakes, but sometimes it's not their fault. Ever heard of information asymmetry? When an average person goes to the auto mechanic for repairs or maintenance, they rely on his knowledge to tell them what fixes they need. An unscrupulous mechanic may take advantage of this fact and suggest fixes that the person may not need to increase their revenue. Of course the person may not know this because of the asymmetrical information at hand. How can you make a truly rational choice in this situation?

Or sometimes the whole market is irrational (as in wall street). Why should i be punished because some douchebag decided it was a good idea to create these CDO's and other ridiculous securities? Why should i be punished because the board room couldn't conjure up a rational compensation package for their executives?

You can cry about 'liberty' all you want, but if i had to venture and guess, a good number of you libertarians would change their tune in a heartbeat if they lost everything they had because the government didn't bailout the banks and restore liquidity in the markets, for example.

 

[halik]

Eh IIRC even Samuelson conceded that markets are less efficient than what he initially thought.

 

[Genx87]

I read an article back about 2-3 months ago that talked about the Fed under greenspan back in the late 1990's changing inflation indicators they used to determine the rate. The argument was made if we used asset inflation the rates would had started kicking in as the housing bubble started to form. Putting the brakes on home construction and purchases.

Interesting idea that on the surface seems to make sense. Same could be said about the internet boom of the late 1990s. When people start seeing an appreciation in double digits annually and are borrowing money to continue to make the bublle bigger at low rates. It definately creates a problem.

The internet and housing bubbles both occured after this supposed shift by the fed. Coincidence? Could an asset inflation indicator have slowed or possibly averted the bubbles?

 

[BoberFett]

Originally posted by: Jaskalas

Originally posted by: Phokus
It's obvious people are not always rational actors, you can find numerous instances of this. For example: people will sometimes avoid preventative healthcare to save on short term costs, but pay dearly for it in the long term. Only idiot 'true believers' in the free market believe people are rational actors 100% of the time.

Your argument sounds like people should be governed and micro managed. An anti-thesis to individual liberty and freedom. Is that what you truly stand for?

We digress. The argument of free markets is not about rationality. This is a subject about ownership and control. It is about power. Who should hold this power, the peasants or their lords? Apparently you think the peasants make mistakes, so to strive for perfection this power should be taken out of their hands. I disagree, perfection is not what we should strive for at the sacrifice of liberty.

I would rather live freely in an imperfect world than in a perfect cage.

Well said.

 

[bamacre]

Originally posted by: yllus
Hypothesis: Markets are perfect. Actors in that market will act rationally to maximize their profits and avoid losses.

Straw man

Free market capitalism is not perfect. No one who understands has ever said so.

What is ironic is that those who see the irrationality of people run toward irrational government. I would much rather deal with irrational people than irrational government. I would much rather deal with the burdens of irrational people than irrational government. And how arrogant and ignorant is it for politicians to think they can manage an economy? An unimaginable amount of calculations, causes, and effects? Very much so. And to those who think we have been practicing free market capitalism, I simply ask how that can be when perhaps government doesn't directly decide the price of a TV or a microprocessor, but has almost total control over the price of money itself. The very backbone of an economy. And when the "Greenspan Put" is offered to businesses, when the Greenspan intoxicating low-interest rates keep the printing machines running and the market flooded with new money, how can one expect them to act rationally?

 

[Double Trouble]

You can not judge if someone acted rationally in a situation until you're able to determine ALL variables that went into the decision. Being incorrect does not mean irrational. The parties may or may not have acted rationally, depending on their analysis of the facts available to them. The author seems to have difficulty separating rational decisions from empirically correct decisions - they are not always the same. He then draws the conclusion that the market needs more government help and intervention to function. He starts off from with a false hypothesis: nobody realistically argues that any market is perfect (the fact that there are taxes and transaction costs already eliminates such a possibility).

 

[Phokus]

Originally posted by: Double Trouble
You can not judge if someone acted rationally in a situation until you're able to determine ALL variables that went into the decision. Being incorrect does not mean irrational. The parties may or may not have acted rationally, depending on their analysis of the facts available to them. The author seems to have difficulty separating rational decisions from empirically correct decisions - they are not always the same. He then draws the conclusion that the market needs more government help and intervention to function. He starts off from with a false hypothesis: nobody realistically argues that any market is perfect (the fact that there are taxes and transaction costs already eliminates such a possibility).

Actually, when you're playing with other people's money (as they wallstreet a-holes did), it's perfectly rational for both the CEO's and their underlings to take on excessive risk, especially the way the board structured their compensation. That AIG guy, cassano who created the CDS that we all know and love, earned hundreds of millions of dollars doing so. And he doesn't have to give any of it back, even though he's basically 'patient-zero' in our economic nightmare. Who cares if the economy goes to hell in a hand basket when you have enough money for multiple lifetimes?

 

[Perknose]

Originally posted by: Jaskalas
I would rather live freely in an imperfect world than in a perfect cage.

Down with stoplights and parking meters! :roll:

I think the OP is spot on. Irrational, knee-jerk responses like the above are emblematic of the obstacles our emotional cowboy electorate will throw up, though.

 

[yllus]

Originally posted by: Jaskalas
We digress. The argument of free markets is not about rationality. This is a subject about ownership and control. It is about power. Who should hold this power, the peasants or their lords?

Maybe, but that's certainly not what this thread is about. Kudos for the Braveheartesque quote at the end, though.

Originally posted by: bamacre

Originally posted by: yllus
Hypothesis: Markets are perfect. Actors in that market will act rationally to maximize their profits and avoid losses.

Straw man

Free market capitalism is not perfect. No one who understands has ever said so.

What is ironic is that those who see the irrationality of people run toward irrational government. I would much rather deal with irrational people than irrational government. I would much rather deal with the burdens of irrational people than irrational government. And how arrogant and ignorant is it for politicians to think they can manage an economy? An unimaginable amount of calculations, causes, and effects? Very much so. And to those who think we have been practicing free market capitalism, I simply ask how that can be when perhaps government doesn't directly decide the price of a TV or a microprocessor, but has almost total control over the price of money itself. The very backbone of an economy. And when the "Greenspan Put" is offered to businesses, when the Greenspan intoxicating low-interest rates keep the printing machines running and the market flooded with new money, how can one expect them to act rationally?

It's not a straw man - it's your refusal or inability to understand the spirit of the message. I don't have the time (or possibly the eloquence) to perfectly phrase what I meant to say in the original post, but I think it's pretty obvious: Even in the perfect market that can never really be, we will still need some amount of government intervention and oversight.

I think most of the respondents to this thread misunderstand what rationality means in this context. Here, it simply means that people will not knowingly act in a way that leads to the destruction of their own wealth. No sane person takes ridiculous risks on purpose.

But here's the problem: Even if all of those people acted rationally about their own assets, of all the brilliant minds on Wall St. (and the Wall Sts. of the rest of the world), nobody cared much for the big picture. Or maybe if people saw it and wanted to act, they didn't have the tools to do anything about it.

Solutions? Aside from the massaging of rules so things don't inch in this direction again, somebody has to take a dispassionate longview. National or international government bodies, with their capability to take the longview on the economy and with the financial tools to put actions behind their words, are the natural choice for this role. It seems obvious that a completely laissez-faire approach leads to the exact problems we're having today.

 

[Phokus]

Originally posted by: bamacre

Originally posted by: yllus
Hypothesis: Markets are perfect. Actors in that market will act rationally to maximize their profits and avoid losses.

Straw man

Free market capitalism is not perfect. No one who understands has ever said so.

What is ironic is that those who see the irrationality of people run toward irrational government. I would much rather deal with irrational people than irrational government. I would much rather deal with the burdens of irrational people than irrational government. And how arrogant and ignorant is it for politicians to think they can manage an economy? An unimaginable amount of calculations, causes, and effects? Very much so. And to those who think we have been practicing free market capitalism, I simply ask how that can be when perhaps government doesn't directly decide the price of a TV or a microprocessor, but has almost total control over the price of money itself. The very backbone of an economy. And when the "Greenspan Put" is offered to businesses, when the Greenspan intoxicating low-interest rates keep the printing machines running and the market flooded with new money, how can one expect them to act rationally?

So you would rather deal with wall street hucksters who almost destroyed the world economy (but thankfully gov't stepped in and saved us) vs. for example, canada's banks that are well regulated and don't have to really deal with this subprime mess?

http://www.nytimes.com/2009/02...opinion/28tedesco.html

You, my friend, are irrational. That is why your extreme ideology is dangerous and thankfully you are considered the lunatic fringe and you nutjobs will never have a say in government.

 

[CycloWizard]

The question remains: is government policy necessarily more rational than any individual's? I have no reason to expect that this is the case. It's simply another case of an oligarchy deciding what is best for everyone.

 

[Phokus]

Originally posted by: CycloWizard
The question remains: is government policy necessarily more rational than any individual's? I have no reason to expect that this is the case. It's simply another case of an oligarchy deciding what is best for everyone.

Here's a case where government policy was more rational than the free market's

http://www.nytimes.com/2009/02...opinion/28tedesco.html

 

[BoberFett]

Originally posted by: Phokus

Originally posted by: CycloWizard
The question remains: is government policy necessarily more rational than any individual's? I have no reason to expect that this is the case. It's simply another case of an oligarchy deciding what is best for everyone.

Here's a case where government policy was more rational than the free market's

http://www.nytimes.com/2009/02...opinion/28tedesco.html

And here's a case where government policy was less rational than the free market.

http://en.wikipedia.org/wiki/Soviet_Union

What's your point?

 

[Rainsford]

I think a lot of people are (predictably) trying to read too much into the argument being made, slapping all sorts of political labels and philosophies onto everything in sight. That's not the point at all. The author is simply saying that a great deal of economic theory is based on the idea that all actors are rational, and that irrational actors can produce results significantly different than what traditional economics would predict. I'd say he provides a pretty good argument that this is true.

He's making a factual (or at least reasoned) argument. If this conflicts with your political philosophy, perhaps you should figure out how you can adapt your viewpoint to reflect reality rather than accusing people of being communists or making ridiculous Braveheart style pronouncements. If only because, as CycloWizard points out, the author ISN'T saying that the government is rational either. He's just providing a counter argument to those who argue for free markets on the basis that economic theory predicts that they will be efficient and successful...that theory could be wrong.

 

[Rainsford]

Originally posted by: BoberFett

Originally posted by: Phokus

Originally posted by: CycloWizard
The question remains: is government policy necessarily more rational than any individual's? I have no reason to expect that this is the case. It's simply another case of an oligarchy deciding what is best for everyone.

Here's a case where government policy was more rational than the free market's

http://www.nytimes.com/2009/02...opinion/28tedesco.html

And here's a case where government policy was less rational than the free market.

http://en.wikipedia.org/wiki/Soviet_Union

What's your point?

I don't know what HIS point is, but I'd say a good takeaway message is that the best idea is probably to come up with a common sense balance designed around particular problems instead of developing economic policy based around generalized, overly broad theories about any particular group. The government can be retarded, but so can the "free market"...so maybe we should stop listening to people arguing that one or the other represents the solution to all of our problems.

 

[bamacre]

Originally posted by: yllus
Even in the perfect market that can never really be, we will still need some amount of government intervention and oversight.

As long as you have the intervention, you need the oversight. That was part of the problem, we had an enormous amount of intervention, and an inappropriate amount of oversight.

I think most of the respondents to this thread misunderstand what rationality means in this context. Here, it simply means that people will not knowingly act in a way that leads to the destruction of their own wealth. No sane person takes ridiculous risks on purpose. But here's the problem: Even if all of those people acted rationally about their own assets, of all the brilliant minds on Wall St. (and the Wall Sts. of the rest of the world), nobody cared much for the big picture. Or maybe if people saw it and wanted to act, they didn't have the tools to do anything about it.

That is one aspect of the Business Cycle Theory, but it faults the government distortions of market conditions for their irrational actions. Specifically artificially low interest rates and monetary inflation.

Solutions? Aside from the massaging of rules so things don't inch in this direction again, somebody has to take a dispassionate longview. National or international government bodies, with their capability to take the longview on the economy and with the financial tools to put actions behind their words, are the natural choice for this role. It seems obvious that a completely laissez-faire approach leads to the exact problems we're having today.

What laissez-faire approach? 😀

It wasn't laissez-faire economics that led to this disaster. Asset bubbles of this magnitude cannot come into existence without an inflationary monetary policy. It's like Schiff says, yeah Wall St was drunk, yeah people were drunk, but it was the Federal Reserve handing out all the alcohol. I mean, can anyone explain how this could have happened under a sound money and a 100% reserve banking system? It couldn't. Because as soon as it, or anything like it, started to grow, interest rates would have shot up and prevented the continuing irrational growth.

But what we are doing, our approach to "fixing" the problem is nothing but exactly what got us into this mess. More borrowing, more spending, more monetary inflation (which will be causing real inflation soon enough). I mean, this is what was done to "fix" the problems stemming from the .com bubble. And oh it was great for a while, but now look at the mess we're in. You can't just print money and increase your debts to avoid a recession. Not in the long run. All you're doing is prolonging the inevitable and making matters worse. You can't just get drunk to cure your hangover. Eventually you have to sober up, and take the short-term pain that comes with it.

 

[bamacre]

Originally posted by: Phokus
So you would rather deal with wall street hucksters who almost destroyed the world economy (but thankfully gov't stepped in and saved us) vs. for example, canada's banks that are well regulated and don't have to really deal with this subprime mess?

http://www.nytimes.com/2009/02...opinion/28tedesco.html

You, my friend, are irrational. That is why your extreme ideology is dangerous and thankfully you are considered the lunatic fringe and you nutjobs will never have a say in government.

You calling me a nut is nothing less than a total compliment.

 

[ElFenix]

I mean, can anyone explain how this could have happened under a sound money and a 100% reserve banking system?

nope, panics and financial crisis never ever happened before we had fractional reserve banking. no, all we had was stable, strong growth for centuries before we ruined it with fractional reserve banking and fiat cash.