Rational or Not?

Was the financial crisis a fully rational response to a poorly structured environment, or is irrationality a fundamental characteristic of economic behavior? I’ve always leaned toward the poorly structured environment side of the argument:

Managing fads, frenzies and finance markets, by Xavier Vives, Project Syndicate: The financial crisis … severely damaged the credibility of financial markets, institutions and traders. More and more people are claiming that markets are characterized by irrationality, bubbles, fads and frenzies, and that economic actors are driven by behavioral biases. …

I believe, however, that there is another explanation … based on rational calculation … by institutions and traders. The problems … in the financial markets have very much to do with lack of good information, misaligned incentives, and, in fact, rational responses to the environment. When information is scarce and unevenly distributed, prices may well depart from the reality of fundamentals.

We see this when new technologies arrive… The Internet bubble is the most recent example, but a similar phenomenon occurred with the construction of railways more than a century ago. It can be argued that the sophisticated loan packages created … in recent years are, likewise, a new and unknown product, so information and experience to aid pricing has been scarce and dispersed.

In such circumstances, prices may well move far from the fundamentals as assessed by a hypothetical collective wisdom that would pool all information in the market. Trading on the momentum of price movements may then become a rational activity that becomes self-fulfilling, as investors decide to “ride the bubble” while it lasts. …

This means that important and relatively persistent departures of prices from fundamental values are possible…, but … a correction … will always follow. … This explains why the market can look like Keynes’s casino in the short term and like Hayek’s marvel in the long term. …

The debate over the irrationality of financial markets is no mere academic argument. If we believe that economic actors are irrational, then we will enact paternalistic policies aimed at controlling behavior or bailing out failed agents and institutions, which could be self-defeating and even dangerous. This may include restrictions on investments by institutions and individuals and intrusive regulation that limits, or dictates, their conduct in the market. The calls to curb speculation in derivatives markets or short sales have this flavor.

If, on the other hand, we believe that economic actors will respond rationally to incentives and information, then we can usefully reform regulatory frameworks with well-targeted measures, including restrictions on off-balance sheet vehicles, tougher disclosure requirements and controls on rating agencies’ conflicts of interests.

Originally published at the Economist’s View reproduced here with the author’s permission.