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Monday, November 3, 2008


Today's Buggy Topic

If you were to read the standard-model economist's view of the electoral system and individual voters, the answer to both questions set out in the title would be a straight-forward --- yes, clearly irrational.  The answers are a direct spin-off of the typical methodology used by economists and those political scientists, less numerous these days thanks to systematic survey-evidence: rational choice.

The Reasons

Rational choice, you see, is invariably translated by economists and those who follow them to mean how an individual --- whether as a worker, consumer, investor, voter, or the like --- seeks to maximize his or her self-interest: how he or she considers household budget options and credit-availability in deciding whether to buy a new TV or not --- or which TV, given prices and quality-judgments --- or chooses to take this job instead of that job, or invests his or her pension funds in the stock or bond markets, and so on. 

In economics, that makes sense --- to a certain degree anyway.  Even in economics, though, starting in the 1960s and 1970s thanks to the work of social psychologists and economists and political scientists informed by their work, the notion of strictly rational economic-man has come in for questioning . . . so much so that a whole new field of behavioral economics has been spun-off.  And it uses a variety of findings uncovered by social psychology --- using a variety of laboratory tests and observations of individual and group behavior in social settings --- that seek to make sense of irrational behavior like "ballooning" stock market exuberance like the dot.com boom and bust or the recent dangerously over-leveraged financial boom, global in nature, based on housing assets here and abroad and creating a world-wide chain of thoroughly unsound, over-exposed creditor-debtor linkages that generated the current financial meltdown. 

Two Free-Market Stratagems  To Salvage Economics as a Powerful Science

Note how, in the face of such irrationally driven booms-and-busts in the financial world over the last two decades --- the Savings and Loans crisis of the late 1980s, the Japanese financial and economic meltdown of the 1990s, the Asian financial and economic crisis of 1997 and 1998, the dot.com boom and crash at about the same time, and the more up-to-date financial crisis here and abroad --- standard economists who adhere to a view of rational economic-man have only two alternative explanations:

  • Either they trot in as Alan Greenspan did such pejorative psychological phrases as irrational exuberance, but assume it's a transient phenomenon (or, in Greenspan's case, left him with stunned disbelief) . . . anyway, a matter for psychologists to deal with, not economists.
  • Or, as with virtually all libertarian free-market enthusiasts, find some government program --- somewhere, some time (no matter how old, decades even) --- that has caused free-markets not to work properly.

So Why Do Financial Booms and Busts --- Including Panic-Driven Meltdowns --- Occur?

Well, that's the $750 billion question, no?  They shouldn't,  given three intertwined premises as to how, in a widely shared view of financial markets that economists of mainstream persuasion --- whether libertarian, New Keynesian, or the like ---these markets are supposed to operate:

1. The efficient market hypothesis: financial markets incorporate all relevant information for current investment purposes

2. No agent-principal problems.  Specifically, intermediary financial agents, whether banks or brokerage firms or insurance firms or mutual funds and the like --- in fact any creditor or investor on one side of a financial transaction and borrower or agent with whom an individual's or firm's capital is entrusted --- are all responsible and trustworthy and can be counted on to carry out proper risk-management and behave responsibly. There are, on this view, no agent-principal conflicts of interest or important information-assymetries that divide them. (In his testimony before the House Oversight Committee two weeks ago, Alan Greenspan's "stunned disbelief" was provoked, he said, by the failure of agent-financial institutions --- in their dealings with the principals like individual investors or other financial firms (creditor-lender-insurance enterprises.)

3. Rational behavior.  Individual investors --- whether a rich person, an ordinary worker considering where to put his pension funds, a large non-financial corporate business with liquid funds to invest, a commercial bank, an investment bank, a hedge fund, a mutual fund, an insurance company, and the like --- tend to be, on the average, well informed about the alternatives, know the risks of their investments, and trust one another (whether there is or is not transparency and accountability easy to pin down and make sense of) --- are all careful calculators here and make their decisions in light of the information available to them.

The Result? 

Not only do financial markets incorporate all useful information at any one point in time, thanks to these three premises --- but, , as it happens, the prices of securities, bonds, and property, the prices of bonds, securities, and property --- and any variants of them --- reflect all this information and hence are accurate . . . given the supply of credit funds and the demand for them by business firms and households.  And as it further happens, a 4th premise intrudes itself here:

4. Individual investors operate with rational expectations. 

Note that rational expectations do not mean --- at any rate, in the financial realm where the efficient market hypothesis prevails in theory --- that all investors are cool-headed, maximizing-utility calculators who recognize and discard misinformation and don't act rashly on bad information (premise 3 above)  --- let alone panic when others do.  On the contrary, the efficient market hypothesis assumes that when information changes, some investors will rashly overreact and others under-react. 

No matter. 

What counts is that, on the average, investors will be located on the mean of a normal statistical distribution (a bell curve), and so the market for bonds or securities (to stay with them) will itself reflect accurately the information in the prices of bonds and equity shares.  As a very good summary in Wikipedia puts it: " any one person can be wrong about the market - indeed, everyone can be - but the market as a whole is always right." 

So Why Do Financial Booms and Busts Occur?

That brings us back to the $750 billion question.  The answer: well, economists are puzzled.  Since such problems aren't supposed to occur, it must be because (for libertarians) the government has mucked things up (stratagem 1 above) or --- for libertarians and New Keynesians  and others who don't think markets are fully and quickly self-adjusting --- it's because of irrationality, and who the hell can deal with irrational economic agents?

Isn't that a job for psychologists?

Back to Today's Buggy Commentary:

Forget, temporarily, these comments that lead to a dead-end for economists who think they are equipped with the most powerful of social science methodologies: rational choice, rational-expectations, and the use of statistical models and strict quantitative data (or good proxies and, if need be, the use of dummy variables and --- if need be further --- the use of logistic regression where the outcome variable of a model isn't itself quantitative, though the explanatory variables are.) 

No, forget all this. 

Just remember: economists are all wizard-like mathematicians and scientific modelers, in command of strict quantitative data and sound knowledge of how economic agents behave.  And so what they can't explain isn't worth explaining unless they happen to be behavioral economists, a tiny minority (though growing) who actually study the way people individually and in groups behave and who are largely ignored by the scientific modelers (unless the modelers are ridiculing them.)  In the end, otherwise,, financial extravaganzas and ultimate panics are matters for psychologists and sociologists --- way, way down on the totem pole of social science --- to grapple with.  Mainstream economists are too busy dealing with the really important things in economic life.

Instead, refocus your mind on the the standard economic view of the rational voter, and two puzzles it can't explain either . . . mathematical wizardry and all.  First, why should any voter even vote, what with the fact that he or she is only 1 voter among tens of millions in the US.  And second, why, in turn, should any 1 voter want to encourage a large turnout of voters --- get the vote out! --- if the more votes cast, the less your own will count?

Click here for the lengthy buggy analysis: