Unpredictably Rational

Common Sense

As we go about our everyday lives we don’t spend a lot of time reflecting on the irrationality of the people around us. Certainly from time to time people do stupid things, but by and large most of us make it through most of our days without driving the wrong way up roads, roasting our dogs in microwaves or buying stocks in stupid companies. Even when we do odd things there’s usually some recognisably rational reason for us doing them.

This version of human rationality is virtually unknown to all brands of economics which largely insist on defining rationality in an irrational way and then sniggering at the human race when it fails to live up to the standards that some rather over-focused economists think it should. The problem for them is that we’re not the irrational ones, they are. The problem for us is that the people that matter listen to them, not us.

Maximal Utility

The definition of rationality that’s at the centre of modern economics is a strange conceit, based around the idea of maximising utility. Underlying this is an assumption that rationality means that we’re consistent in our choices: faced with the same situation we should always do the same thing. From this position economists have then spent a great deal of time trying to design experiments to show that this is what we do, which is just about possible when you remove all vestiges of reality from the situation (see, for instance, Be a Sceptical Economist).

However, real-life isn’t like this. We rarely, if ever, face the same situation twice: life is a stream and we can’t stand in it twice. Mostly we must face each situation anew and make new choices each time. Obviously we rely on past experience to guide us in our decision making and, as we all have different experiences to guide us, we make different decisions. We even make different choices ourselves between very similar circumstances and most of us will see nothing wrong in this. It’s certainly not irrational to change our minds – as Keynes himself said, when the facts change you should change your mind: it would be stupid not to.

So when a pseudo-science like economics tells us that when we change our minds we’re being irrational it has a lot of explaining to do if it’s to genuinely convince anyone that it has anything to offer the real-world of finance and human interaction. Unfortunately there’s a lot of the world which is convinced by models which pertain to explain everything important which offer spurious but comforting precision about the future. Economics, as a whole, taps into this need and has been remarkably successful in persuading many people, some of whom are quite intelligent, that it has something to offer.

Framed by Economists

At the root of this problem is this amorphous concept of “rationality”. The idea that rationality is a desirable quality for humankind has a very long history, reaching back to Socrates and then passing down a long line of philosophers. Rationality and intelligence are, broadly speaking, felt to be good things – apart from amongst groups of teenage boys who generally seem to think that possession of a working brain is a failure of education which can be fixed with a good kicking.

Because of this we’re predisposed to place a higher value on any approach which carries the label of “rational” and to place negative connotations on concepts associated with “irrationality”. Economists have neatly parasitized this inclination by taking a quite stupid definition of rationality and then holding it up as a shining example of what we should all aspire to. We have all, quite literally, been framed by the economists.

Nudged

This problem, unfortunately, extends beyond the traditional ideas of economics to the more modern psychological approaches underlying behavioural finance. The idea that people are deviating from some desirable norm of rational behaviour – exhibiting behavioural biases – is woven into the very fabric of behavioural economics. Of course, such approaches are better than the alternatives, as we saw in Utility, The Deus Ex Machina of Economics, the assumption that there is a desirable level of rational behaviour underpins them still.

Even worse, as outlined in Investor Decisions - Experience Is Not Enough, the current definition of behavioural finance leads to what appear to be some irrational predictions, justified by some artificially constrained experimental situations. The consequence of this is that behavioural economists are quite comfortable in offering us advice on how we should behave – or invest. They see nothing wrong in finding ways of nudging us to make us less irrational and positively glow in the satisfaction of finding ways of valuing differences in human behaviour. They can do this because they “know” that there’s a set standard of rational behaviour to which we should all aspire.

Irrational Economists

Of course, a world in which we were all selfish maximisers or even simply brutally logical would be a horrible, horrible place. So the perseverance of economists with these rational choice theories, even in the clothing of behavioural sheep, is an odd thing. Peter J. Hammond, in Rationality in Economics, suggests four reasons for the subject’s attachment to a frankly strange theory.

Firstly he argues that simple inertia is a factor – rationality gets taught to each succeeding generation of economists and they pass it on. Secondly he thinks that the mathematical clarity of the models is a major issue – the ease with which they can be used to solve problems in economics makes replacing them with messy real-life difficult and unattractive. Anyone who’s read enough economic papers will sympathise with this view: at times it almost looks like economists feel they need to write really, really complex equations in order to justify themselves.

Free-market Apologists

Thirdly he suggests that economists may be operating as apologists for free market economics, essentially engaged in developing theories that justify the behaviour of markets and their participants. A few years ago this would have seemed an extraordinary suggestion but no longer: with hindsight it’s perfectly clear that many economic theories were at best descriptions of what was happening in markets and at worst post-hoc justifications of a culture of excessive greed and risk-taking.

This model of economists as apologists comes from a fairly simple association. The idea that markets are efficient and that people are behaving rationally fully justifies virtually any behaviour in the markets. As Hammond puts it, wryly:

“Defenders of free enterprise would have the force of their arguments considerably reduced if consumers were known to be behaving irrationally. Yet then economists might have a new role to play advising consumer organizations instead of business. Perhaps, however, they see that business can afford to pay better.”

Fourthly he points out that experimental evidence could support the ideas of rational economics only, as we’ve frequently seen on these pages, they don’t. Not even economists behave the way that rational agents are supposed to once they leave the chalkboard and start engaging with the real-world. The truth is that the real-world is far too messy to allow for the type of rational behaviour that economists desire. We don’t make decisions through a logical step-by-step analysis but instantaneously in the context of the social situations that we find ourselves in. Most of the time we make things up as we go along, hoping for the best and, generally, not anticipating the worst.

Great Works

It’s an unfortunate by-product of economics that this perfectly normal human behaviour gets labelled as irrational and then derided. It’s not the “irrational” behaviour of everyday people that should be being sneered at but the “rational” attempts of economists to build all-encompassing models that can be used to straightjacket peoples’ behaviour. We shouldn’t be dismissive of this either – early attempts by psychology to define similar concepts of good and bad behaviour led to forced sterilizations, the state sponsored dismembering of families and, ultimately, the development of eugenics and its terrible legacy.

Behavioural finance is a step in the right direction – at least acknowledging that people don’t behave as rational economics would want them to. However, it needs to go further, to accept that irrational human behaviour is no such thing: it’s created wonderful art, astonishing architecture, beautiful music and probed the very corners of creation. It's just that our rationality is rather more unpredictable than economists know how to handle. Time for a rethink.



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