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.
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In this sense rational/irrational always strikes me the same way Spock's Vulcan logic works. He would tell Kirk that acting on emotions was not logical. But since humans have emotions and allow them to influence their behavior, then it is not illogical to take that into consideration when making a decision.
Similarly in Economics, I may do something stupid because I have my priorities out of whack, but *given* a set of priorities, the result may be rational.
Defining rationality for the trade-off between short- and long-term interests is not trivial. The problem is that one's priorities change. Given that that is observable in others, it arguably isn't rational to assume that one's current priorities will remain fixed.
The bubble as a whole may have been irrational, but it resulted from the decisions of numerous people almost all of whom were acting rationally. The non-investor homebuyers who got much more house than they could have possibly afforded with a traditional mortgage, the mortgage broker who arranged the toxic loan for a big cut of the proceeds, the Wall Street trader who pooled the toxic loans into exotic securities and got a ginormous bonus, and the investor who bought the top-rated tranche because it and other comparable products were the only fixed-income investments with investment grade ratings and income that was more than a pittance, all acted in their short-term interests. That their interests and the interests of larger organizations, or society as a whole, were incompatible is the problem.
There will always be some group of people whose short-term interests are incompatible with society's. Any system can and will be gamed. The trick is to make sure that this group remains as small as possible.
I think your definition of 'irrational' is a bit too narrow. We live in a rational universe (with some fuzzy edges at the very small scales). Every action we take has a neural generator. In that sense, every action we take is rational. Why you allow cognitive dissonance to be irrational, while you see emotional attachment as rational isn't clear.
Take for example the bankruptcy story. Just because he cared for his kids, which is a socially acceptable trait, doesn't mean he wasn't experiencing "biased cognitive processing".
I would say that #2 and 3 definately fall into this category of biased cognition. I'm totally on board with you for #1 (garbage in, garbage out). For 4, it seems to me to depend on the scale your looking at. Selfishness is pretty sensible, but when you start looking at societies, it can easily become so biasing as to prevent you from finding population-wide optimal outcomes. For 5, I'm not quite sure what your getting at.
It's important to distinguish between rationality and rationalization. I think Ed Andrews' explanation for why he bought a house he knew he couldn't afford was rationalizing a decision he made for irrational reasons. It's rationalization that lets you eliminate rational choices until you're left with only the one choice you really wanted in the first place.
I mostly agree, but the core of the problem seems to be the missing consensus about what constitutes "rationality". For the economist, it is basically having a set of well-defined preferences, and "well-defined" almost exclusively means transitive. The everyday use of the word is of course much more ambiguous...
Why you allow cognitive dissonance to be irrational, while you see emotional attachment as rational isn't clear.
I'm not sure exactly where you're seeing the idea of emotional attachment as rational.
Cognitive dissonance is entirely irrational. When you're making decisions based on information you've good reason to believe is false, when there is a lot of evidence that the choice you have come to is totally wrong, then yes, you are irrational.
On the other hand, there are times when emotional attachment can be a factor in making a non-rational or arational choice. This is especially true if you truly believe the false information that has led you to make a non-rational choice - like a religious belief. You start with a belief that has been consistently reinforced and the reinforcement includes repeated claims from prominent speakers, that the evidence claiming said belief is wrong, is seriously flawed or otherwise biased. You have a significant emotional investment into the underlying belief, but honestly don't care about the minutia - including the minutia relevant to the decision.
It is not irrational to ignore that there is evidence out there that contradicts this belief of yours. I would argue that it's arational - outside the dichotomy of rational/irrational.
On the other hand, said belief can become irrational if you decide to investigate the evidence that contradicts it and seek increasingly desperate reconciliations of reality and your belief. That being a topic I am all too painfully familiar with, through a lifetime of experience...
Many of the points you make about the relationship between evolutionary theory and economist's concept of rationality and are explored in a lesser known book on behavioral economics called "Basic Instincts: Human nature and the new economics", by a guy called Pete Lunn from Ireland. He's a neuroscientist-turned-economist who looks for reasons why the human brain might have developed the economic biases it has. He argues that behavioral economics is leading us to home in on new assumptions that will form the basis of an alternative microeconomics; a classic scientific revolution beginning with empirical refutation. The book has prompted some debate about the impact of behavioral economics in the UK and Ireland, yet is virtually unknown in the US as of now. But the argument is a scientific step up from Ariely, Shiller and Thaler.
I think it has taken people so long to see that very few of the attitudes we have and decisions we make have a 'rational' basis, because we hate the idea of being ruled by our emotions. But the truth is, we basically are. The limbic system is far more powerful than the cerebral cortex in controlling behavior.
This is gleefully exploited in politics, perhaps more effectively these days than ever before.
Engaging a bubble, knowing that it is a bubble that will burst before long, isn't irrational, but most people participating in the bubble do not belong to this group.
At least in the journalism, etc., that Shiller reviews for the housing and stock market bubbles (whether the recent ones or back to the 1890s), most people think that prices can only go up, up, up -- land is fixed while population is growing, or whatever, so your house can only appreciate in value. And most people think the stock market shows a strong upward trend over time, notwithstanding the boom and bust.
But neither of those is really true. So, most people don't realize that it's a game of musical chairs, and that your goal is to time it right so that you get out at the optimal moment. And that's frequency-dependent -- if everyone decides to get out just a bit sooner than the other rational players...
I think sometimes we confuse the non-optimal with the
irrational. We commonly solve things suboptimally, using
rules of thumb which are good enough. The more precise the
answer has to be, the more time and effort it takes. If
one includes the cost of solving the problem, then the
rough answers are better. While they may not best
solve the exact problem, they do optimize the
bigger, practical, problem of: the original issue + cost of
solution.
A bubble distorts the information available out there.
During boomtime, optimistic scenarios get more press.
Being rational does not help, since the input data one
rationally analyzes is itself skewed. There is always
far more data than any human can ever look at, for any
problem. We filter and look at a subset. Increasingly,
we depend on the media to do this filtering for us, to decide how to invest. The media's filter, in turn,
depends on the prevailing mood. There is no irrationality
here. Just a chain, each part of which may be rational and
optimizing locally, but the sum not being globally optimal.
I'm too tired to chase the reference at the moment, but I recently saw an article claiming that Andrew's wife had very little spending discipline even after having gone through a previous bankruptcy. That - and its omission from Andrew's "confession" - puts different lights on the story, but also underlines the Mad Biologist's point:
The "rational" Homo economicus, that paragon of Republican reality, would immediately file for divorce, Brady Bunch be damned.
Speaking of Republicans, try running through the same sort of questions as above regarding the repeal of New Deal banking regs, appointment of do-nothing regulators, and other quiet robberies of the public trust. Phil Gramm and his ilk are doing pretty well, even if losing a bit of their loot in the wreckage which their own unethical "rationalities" have dumped us all. (Yes, I know Clinton signed much of the worst of it: most Democrats are at least 1/2 Repub themselves imho...) Madoff and Abramoff are the only top players whose actions have so far been shown "irrational" since Ken Lay went down.
And as for those requested "shiny pebble" studies: Madison Avenue has had researchers on the job since they were located along Madison Ave. You can, with a little study, reverse-engineer their conclusions by analyzing today's intensely-calculated media output. It all boils down to bright colors, motion, faces, and tits 'n' ass.
Oh, and another couple of tangents:
A) The "rational" masterminds who repealed the Glass-Steagall Act, (re-)appointed Alan Greenspan, carved out loopholes for derivatives, hedge funds, etc, did all this in full historical knowledge of both the 1929 crash and Reagan's S&L de-reg disaster. Lots of method in the recent madness...
B) Never mind those shiny pebbles: the objects of suspicion in the present trainwreck are the happy pills which have kept the current generation of financiers "functional" for decades. Would brains whose Selective Serotonin Reuptake was not Inhibited have acted with less of that irrational exuberance Greenspan simultaneously admitted and denied?
Twice I've received a money order for much more than I paid for; in both cases the clerk at the bank added an extra zero to the end of the dollar figure. The first time, I went back to the bank and corrected the mistake without thinking about it. The second time, I knew I was going to come up $300 short on rent when the end of the month came around, and so, an extra $360 could really be helpful ... but I went back anyway.
I'm glad to see someone is debunking the "irrational behavior" theory. Everyone acted completely rationally, and they generally acted for the same economic reasons. Bubbles are perfectly rational. If you don't play, you can't win, and you may miss a once in a lifetime opportunity. Even Isaac Newton got involved in the South Sea Bubble, and for perfectly rational reasons.
Of course, every bubble has its limits, but it is tough to figure out when to exit. Newton managed to bail, but he bailed too soon, so he bought back in. Then, he got wiped out with everyone else.
That's why institutional learning is so important. If you assume everyone behaves rationally, you can still get all sorts of bubbles. Damping the system by putting in time limits and leverage limits can improve stability, but there is always the completely rational search for a way to avoid these limits.
This kind of argument always seems to jump from one simple-minded point of view to another, with individual irrationality being the new simple idea.
The points I'd like to see addressed are:
1.) Ideal markets reward rationality and punish irrationality. In these markets irrationality is not a problem except for the irrational individual, who soon is knocked out of the game. But bubble markets reward irrationality and punish rationality -- up until they collapse. So it's not a problem of individuals or groups of individuals, but a market structure problem.
2.) Economics assumes non-communicating individuals who choose independently and are individually punished and rewarded. But real world individuals communicate with one another. If a form of irrationality is socially transmitted by communicators and becomes a shared value, in combination with #1, irrationality is again rewarded rather than punished. The market only punishes irrationality if there are enough rational people in it.
And at that point, long-term irrationality becomes short term rational: "The market can stay irrational longer than you can stay solvent." People who stay out of a bubble, or who jump out too soon, lose a lot of money (which they are forbidden to do if they're investing others' money.)
Thank you...
"For instance, understanding economic bubbles doesn't really make sense unless one accounts for irrationality"
Not true. Rationality does not entail omniscience. The Austrians have a theory of economic bubbles that does not require any of the actors to behave irrationally. It just requires a central bank, or fractional reserve banking. Remember, if you ever understood, the term rationality in economics is a specialized term, and does not mean someone who always makes the right decisions. A "rational actor" is one that makes choices and has an aim in mind.
Brian Macker: "Remember, if you ever understood, the term rationality in economics is a specialized term, and does not mean someone who always makes the right decisions. A "rational actor" is one that makes choices and has an aim in mind."
Well, many economists in their public statements do not use "rational" in that way. They criticize aims and viewpoints that differ from theirs as irrational. The paragon of economic rationality is the sociopath. Any deviation from sociopathy runs the risk of be criticized as irrational.