Rational Irrationality

How Markets Fail by John Cassidy is one of the best books I’ve read in the last couple years. It is first about ideas. It then integrates them in helping us understand what went wrong with our financial system. The first third of the book contains a history of economic thinking from Adam Smith, Hayek, Keynes, Arthur Pigou, von Neuman, Kenneth Arrow, Milton Friedman, Robert Lucas, Kahneman and Tversky and many others. It details the increasing use and sophistication of mathematics in economics and the revolutionary insights of game theory. The stagflation (the inflation rate jumped into double digits but unemployment did not fall) of the 1970's was an event that mainstream Keynesians could not explain, paving the way for the revival of conservative economics. Friedman’s view that the real culprit of the Great Depression was the Federal Reserve’s failure to counteract the decrease in the money supply also paved the way.

Cassidy then shows how these ideas got incorporated into theories about finance (efficient market theories). Finally, he explains how this led to the financial meltdown, including the seizing of credit markets, which continues to affect us today. In doing so, he explains some of the complicated financial innovations such as structured investment vehicles (SIV’s) and credit default swaps. This sounds daunting, but Cassidy is so knowledgeable and such a good writer that he pulls it off.

John Von Neuman, a genius who made significant contributions in many areas, formulated game theory. Game theory is an inquiry as to how actors will behave when they have to take into account the actions (or expectatios) of others. The prisoner’s dilemma is a commonly occurring situation in which rational individuals will choose an outcome that is not in either’s best interests even in something as simple as a two-person game. With ten people in becomes virtually impossible to sustain a cooperative outcome. In the economic arena, it helps explain situations where rational self-interest in the marketplace leads to socially damaging outcomes. A general manifestation is the Tragedy of the Commons; a more particular outcome is destroying the planet by industrial pollution. This is one type of “market failure” (externalities). Since one of the insights of classical economics is seeing how rational self-interest can lead to mutually beneficial outcomes (the invisible hand), it poses a potential problem for this theory.

Frederich Hayek’s big insight is that prices convey information which allocate resources. Firms do not need to ask consumers what to make and how much; prices transmit the information. This results in what he calls an “economy of knowledge.” Individual participants in the market need to know little to be able to take the right action. Hayek later expanded this efficiency of the market into a political theory; he viewed the free market as the only effective guarantor of individual freedom. The failure of communism only reinforces this view. However, just because central planning failed, how can we be sure that the price signals the market sends are the right ones? The general equilibrium theory was supposed to answer this question by showing the existence of a set of market prices at which all goods will be supplied in exactly the quantities that people demand. This can be done, but only by assuming that each industry contains many competing firms and that the firms are not able to lower the unit costs merely by raising output. At these prices, it is not possible to make anybody better off without making someone else worse off. This theory was very persuasive to economists because of its mathematical elegance.

However, in any economy, even the most efficient, some people will fare off better than others. How do we decide which economic outcome is preferable? Who decides? Kenneth Arrow’s work showed how the models could do this. I will leave out the intriguing details, but he showed how the free market could generate a Pareto-efficient outcome (meaning you cannot make one person better off without making someone else worse off. However, the difficulty in applying the theory to reality was not only the restrictive assumptions, but later work showed that in order for such a formal model to work, people would need access to an infinite amount of computation capacity (there had to be perfect information). The axioms of individual rationality and perfect competition were not sufficient to determine what would happen.

On top of this, the work of behavioral economists following Kahneman and Tversky have shown many of the foibles of human reasoning. We are not able to approach making the calculations required by classical economics. We are very bad at probability. Instead, we use “rules of thumb” (heuristics) to reach conclusions. These are “wired-in” and have been selected for by evolution. For much of human history, it was more important to think quickly than to deliberate. One of the irrational responses is to go with the herd despite available contrary information. This leads to bubbles. But it is rational for financial actors to go along with the herd. They continued to take such risks because everyone else was doing it and making a lot of money. If they didn’t, they would not have had jobs. But this just made the bubble bigger. As opposed to the negative feedback loop of general equilibrium theory, this is a positive feedback loop.

George Akerlof showed how hidden information can lead to market failure (adverse selection). This is potentially an issue in any market where the quality of goods is difficult to ascertain other than by casual inspection. The problem of hidden information eventually shows not only is there not a single set of assumptions under which markets are Pareto-efficient, but that with real economies (all those that exist outside of economics textbooks), they are never Pareto-efficient. There is always a potential policy intervention that could improve the welfare of at least one person while leaving nobody worse off. Just as externalities lead the system to issue the wrong price signals, so does hidden information.

Instability is true in most markets but most important in financial markets, for its failure has cascading effects on the rest of the economy (it is also important in the health care market, leading some people to not be able to get any insurance, not just expensive insurance). In an economic downturn, lenders have difficulty ascertaining which borrowers are good risks. This was amplified in recent history by financial innovation; the markets for items like credit default swaps disappeared, making it impossible to value them, which was exacerbated by the opacity of various large financial actors like hedge funds and investment banks. And because of the opacity of credit default swaps, it was difficult to determine who owed what to whom. This implosion was also exacerbated by the myth that financial institutions could mathematically model risk (hello Nassim Taleb), which contributed to rising leverage levels and more risk. A house of cards getting bigger all the time as well as more fragile, with the big players surfing the bubble.

In the efficient market view of finance, speculators play a stabilizing role, purchasing undervalued assets and selling short overvalued ones. However, during bubbles speculators play a destabilizing role (it seems like they do when the bubble bursts, too). Hyman Minsky went beyond Keynes in describing how booms and busts are created. The process does not depend on any external shock. The primary causes come from the competitive forces that are at work in the financial sector. Any period of stability “leads to an expansion of debt-financing,” with innovation and novel financial assets. Efficient markets theory turned on its head. This is a theory of rational irrationality, with the individual rational actions of banks and other financial firms serving to destabilize the entire system.

Cassidy argues that the current crisis is similar to the S & L crisis of the 1980's. The central causes are the same; a misguided faith in the free market, deregulation that was heavily influenced by industry lobbyists (and the conservative movement) and an unsustainable real estate boom. This does not mean that government is usually better than markets at allocating resources or that markets are not a means for driving prosperity. However, the debate should not be between laissez faire capitalism and a command economy. Markets do enable people to make mutually advantageous deals (win-win games). The place to begin looking for appropriate government action should be centered on market failure, which Cassidy calls reality-based economics (vs. utopian economics). The primary source of economic instability is the short-term rational (at the individual level) actions of the financial sector. Wall Street should be one of our biggest concerns and it needs to change. Business as usual is no longer rational for our society.