Tuesday, October 15, 2013

Rationality: The Issue Is Not the Issue

The latest round of sort-of-Nobels, awarded to Fama, Hansen and Schiller for work on (or in Hansen’s case related to) the dynamics of asset markets, has brought up once again the question of whether economic models should assume that individuals are rational.  Mark Thoma makes the case for rationality as a reference assumption which we can vary to see how the real world might differ from the “ideal” one.  Undoubtedly, the politics of the Fama-Schiller divide map into intuitions about rationality and the role of the state.  In the Fama/freshwater world people are rational, and the government can succeed only by duping them, which it can do only temporarily at long-term cost.  In the Schiller/saltwater world people are less than fully rational, and careful government action can improve market outcomes over some potential time horizons. Thus the intensity with which otherwise rational people debate rationality.

Here I would like to propose that the rationality dispute, while important, is not that important (an obscure reference to Lewis Mumford on Wilhelm Reich).  In fact, for most macroeconomic questions whether or not you assume individuals are rational has almost no bearing at all.  Here is an off-the-top-of-my-head list of modeling assumptions modern macroeconomists make that are not about rationality but actually drive their results.

1. Market-clearing equilibria are stable everywhere.  This is the default assumption.  The main departure that gets invoked to yield “Keynesian” outcomes is delayed adjustment to clearing, as in a two period model where adjustment occurs with a lag.  Another is the use of steady-state outcomes in matching models of the labor market, in which wages adjust to achieve a constant ratio of unemployed workers to job vacancies.  But stability concerns run deeper.  (a) Many markets appear to adjust to a permanent state of excess supply; in fact this is one of the hallmarks of a capitalist economy, just as permanent shortages result from central planning.  We don’t have a good understanding at the present how this works, and this includes not having a good understanding of the adjustment process.  (b) Expectations feed back into the adjustment process of markets through changes in the valuations people give to surpluses and shortages, as Keynes noted in The General Theory.  The difficulty in drawing up realistic models of expectation formation with heterogeneous agents is not just a matter of identifying the location of an equilibrium but also its stability properties.  (c) The Sonnenschein-Debreu-Mantel result is about the stability of multi-market equilibrium.  It says: in general they aren’t.  Rather, out-of-equilibrium trading generates path dependence.

2. Firms are long run profit-maximizers.  It is convenient to be able to treat households and firms symmetrically, but firms are not individuals.  (And households are not individuals either, but that may or may not wash out at the macro level.)  The structure of incentives that translates individual choice into the collective choice of organizations can hardly be assumed to achieve perfect correspondence between one and the other.  As we’ve seen, this issue is especially acute when financial institutions are involved.

3. Default does not occur in equilibrium.  This is a corner solution and therefore intrinsically implausible.  Rational decision-makers will usually accept some positive default risk, which means that defaults can and will happen; they are not disequilbrium phenomena.  Gradually we are beginning to see models that consider the systemic implications of ubiquitous default risk.  In the future, I hope that no macro model without default will be taken seriously.

4. All uncertainty is statistical.  No it’s not.  And any model in which, for instance, individuals fine-tune today’s consumption as part of a maximization that includes their consumption decades later, based on a calculable lifetime expected budget constraint, is grossly implausible.  Similarly with long-lived investments.  This is the point of Keynes’ animal spirits, and it strikes at the heart of conventional intertemporal modeling.

5. There is no interdependence among individuals or firms other than what is channeled through the market.  Everything else is a matter of simply adding up: me plus you plus her plus Microsoft plus the local taco truck.  We live in isolated worlds, only connecting through the effects of our choices on the prices others face in the market.  This assumption denies all the other ways we affect one another; it is very eighteenth century.  In all other social sciences it has disappeared, but in economics it rules.  Yet non-market interconnections matter mightily at all levels.  There are discourses in asset markets, for instance: different narratives that compete and draw or lose strength from the choices made by market participants and the reasons they give for them.  Consumption choices are profoundly affected by the consumption of others—this is what consumption norms are about.  The list of interactions, of what makes us members of a society and not just isolated individuals, is as long as you care to make it.  Technically, the result is indeterminacy---multiple equilibria and path dependence—as well as the inability to interpret collective outcomes normatively (“social optima”).  Also, such models quickly become intractable.

6. Rational decision-making takes the form of maximizing utility.  Utility maximization is a representation of rational decision-making in a world in which only outcomes count and all outcomes are commensurable.  This is another eighteenth century touch, this time at the level of individual psychology.  Today almost no one believes this except economists.  It is not a matter of whether people are rational, by the way, but what the meaning and role of rationality is.  It is not irrational to care about processes as well as outcomes, or to recognize that some outcomes do not trade off against others to produce only a net result.  (This is what it means to be torn.)  The utilitarian framework is a big problem in a lot of applied micro areas; it is less clear what damage it does in macro.  I suspect it plays a role in wage-setting and perhaps price setting in contexts where long-term supplier-customer relationships are established.  We have a few models from the likes of George Akerlof that begin to get at these mechanisms, but their utilitarian scaffolding remains a constraint.

These are enormous problem areas for economic theorizing, and none of them are about whether or not people are “irrational”.  Rather, taking in the picture as a whole, debates over rationality seem narrow and misplaced.  Alas, the current Riksbank award will tend to focus attention on the status of the rationality assumption, as if it were the fault line on which economic theory sits.

I don’t want to be a complete curmudgeon, however.  I think microeconomics is steadily emerging from the muck, thanks to an ever-increasing role for open-minded empirical methods.  Not only is the percentage of empirical papers increasing at the expense of theory-only exercises, but the theoretical priors within empirical work are becoming less constraining as techniques improve for deriving better results from fewer assumptions.  Macro is another story, though.  Here the problem is simply lack of data: there are too many relevant variables and too few observations; traction requires lots of theory-derived structure.  If the theory is poor, so is the “evidence”.  How do we escape?

19 comments:

  1. Anonymous3:47 AM

    "Many markets appear to adjust to a permanent state of excess supply"

    So by Say's Law there is excess demand in other markets. Which is which?

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  2. One of the few bits of econ that most may agree on: Schiller is spelled Shiller. Irrational? Perhaps. Supported by empirical data? I'm not good at math. ;)

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    1. Oops, a fingerfehler -- I've been spending too much time in Germany. Also, I don't want to imply that the guy is a shill for anyone.

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    2. Fingerfehler! :) Understandable, I always want to spell it Schiller, and I keep checking to make sure it is really Shiller!

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  3. Rationality is a many faceted container.

    In my judgement, modern macroeconomics nearly ignores the concepts of monopolies and group-think. These two concepts encompass a large part of human economics. Both concepts are very rational but are emotional, not mechanical.

    An emotional decision results in constant results that continue until the mechanics fail or emotions change. Both emotional-decision-changes-on-a-group-level and mechanical failure result in discontinuities in macro-economic trend traces.

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  4. Empirics is a rabbit hole for economists.
    Here's the problem, without physicists, we wouldn't have landed on the moon. Without economists we wouldn't _____ (?) Fill in the blank. we'd still have money, an economy, businesses, taxes, debt, income, wealth. - we seem to have recessions and good and bad economies independent of economists.

    We need a little imagination in the field - empirics implicitly says the possible is contained in the past. (although even history tells us it doesn't always repeat itself)
    Tell us all something we don't know already - EMH: we can't all beat the market ?!?! duh... - give something we wouldn't have without it. In fact, here's an idea, less inequality.

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  5. This is one of the most uninformed posts I have read here. I do like the picture of Spock though. Here are a few issues.

    First, someone needs to read their Coase. As with externalities, suggesting that people may be less than fully rational does not constitute a prima facie case for government intervention. You also need to have a) a very specific definition of what rational behavior is in order to be able to identify deviations from it, b) government official who are not subject to the same lapses in rationality as everyone else. Fama's point is that when it comes to asset prices we don't even meet (a), since there is no model that can determine with certainty when an asset price reflects a bubble. For example, real estate prices in Australia experienced an increase similar to that in the US but they have not collapsed as of yet, and there is a lot of disagreement even withing the government as to whether the increase reflects a bubble or not. This is why, as Cowen wrote in the marginal revolution, many of Shiller's proposals involve empowering markets rather than having the government step in.

    On point 1, Keynesian theory is hardly the only explanation, and probably not the best one, why markets may not be at the market-clearing equilibrium. In fact, in search-theoretic models the market NEVER converges to a Walrasian equilibrium, and in recent decades there has been an explosion of macroeconomic papers that incorporate search frictions. Sorry you missed that.

    Many of the other points are valid, but the issue is not that macroeconomists do not want to make their models more realistic. The problem is that once you add, for example, ambiguity aversion the model can generate such a wide range of predictions that it becomes useless.

    I can keep going on, but you get the drift.

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    1. Anonymous8:24 AM

      "The problem is that once you add, for example, ambiguity aversion the model can generate such a wide range of predictions that it becomes useless. "

      This is, as far as I can see, the strangest thing about economists. Everyone knows that more or less every model can predict absolutely whatever as soon as you start to make it more realistic - but does this lead to the conclusion that we do not know much yet? No, it only means that we should keep certain parts of reality outside the models. The only answer I can get from my colleagues is some kind of excuse that "everyone does it".

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  6. Dear CA, before branding me uninformed, please read what I've written. I actually referenced search equilibria in my post (which at best explain only some of the excess supply markets). I didn't argue that governments have the capacity to solve all the problems markets can't. (I didn't even say that the problems I identified were necessarily social problems, only problems for a certain kind of market analysis -- i.e. problems for economists.) And I didn't say that economists were anti-empirical (quite the contrary for micro), only that empiricism is not an escape route for poor theory on the macro side.

    Sorry that the words slid past. Happy you liked the picture, though.

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    1. Dear Peter, since my line of work involves publishing at refereed journals, I can tell you from experience that it is very tempting to blame for every rejection the idiot referees who simply didn't "get it". This is also the least productive way to go about it. Maybe you should start by asking if you perhaps didn't make your point as clear as you should have.

      What is clear, is that you intend to take a swing at macroeconomics; this is a favorite pastime activity these days, and you certainly have the right to partake in the fun. My problem is that you should at least do it for the right reasons. Here is what you wrote:

      "In the Schiller/saltwater world people are less than fully rational, and careful government action can improve market outcomes over some potential time horizons."
      Some references and examples pertaining to asset markets would be useful. What particular policy is implied by Shiller's work that is also antithetical to Fama's work?

      "Here is an off-the-top-of-my-head list of modeling assumptions modern macroeconomists make that are not about rationality but actually drive their results.
      1. Market-clearing equilibria are stable everywhere."

      As I pointed out, a plethora of macroeconomic models do not assume that the economy converges to a market-clearing equilibrium, and many of those that do produce multiple equilibria, some of which are unstable. The fact that you referenced search theory is irrelevant. What you assert here is simply not true. So either you are unaware of all these papers, or you are lying. By assuming it was the first I tried to give you the benefit of the doubt, but feel free to correct me.

      "6. Rational decision-making takes the form of maximizing utility...It is not irrational to care about processes as well as outcomes, or to recognize that some outcomes do not trade off against others to produce only a net result. (This is what it means to be torn.)"

      First, you need to re-read the von-Neumann-Morgerstern theorem. Second, being torn is precisely the idea behind an indifference curve, which is derived from utility maximization. Third, nobody says that you cannot modify the utility function to include preferences over processes, consumption of others (see your number 5) and so on. For example, taking a cue from behavioral economists, a number of macro models incorporate habit persistence in the utility function. By doing so they offer explanations regarding, for example, the equity-premium puzzle. However, solving such dynamic models is computationally much more difficult. The question is always how much insight one gets in exchange for the increased complexity. The goal of a model is not to be realistic, it is to be useful.

      I can keep on, but the point is that portraying macroeconomists as a homogeneous group obsessed with specific assumptions is simply incorrect. In addition, macroeconomists do not rely on the assumptions of profit or utility maximization any more than microeconomists do when they discuss demand curves for goods or factors of production, income and substitution effects, and so on. If you really want to move away from all that, there is a framework pioneered by Nelson and Winters: http://www.amazon.com/Evolutionary-Theory-Economic-Change-Belknap/dp/0674272285
      But realize that this is not a micro vs. macro issue, and that moving in that direction involves also giving up your Keynesian heroes, including Keynes himself, and embracing Schumpeter.

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    2. I've been edited a bit in my time too, but I'm regarding you as a peer, not an editor.

      1. I'll pass on documenting how departures from rationality can be used to justify government intervention. I'll treat it as common knowledge. (And I have class in five minutes.)

      2. Referencing search theory is not irrelevant if I am accused of not knowing about search theory.

      3. Baseline macro models assume stable, market-clearing equilibria. They can be touched up to allow for unstable or non-clearing equilibria in specific markets -- typically labor. If I didn't make this clear in my post, I hope it's clear now. My criticism is that non-Walrasian markets may be far more widespread than this protocol allows.

      4. There are only outcomes in vN-M utility. What are you reading that I'm not. (Or smoking?)

      5. Indifference is not being torn, it's being indifferent. For the difference, consult i.a. Martha Nussbaum. (No reference now, class calls.)

      6. No, I was not arguing that macroeconomists are homogeneous; clearly they aren't. I was identifying other fault lines that I thought were as consequential if not more so than rationality/departures-from-rationality. If I gave the impression that the divisions are highly unequal, it's because they are.

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    3. And in most journals the refereeing is done by peers. Anyway...

      1. But you evoked the work by Fama and Shiller. So please enlighten me when you are done with class, and no, general references to soft paternalism will not do.

      2. You are accused of failing to mention how prevalent it is in macro, especially these days. See also below.

      3. I have never heard of any macroeconomist referring to a model as baseline. What makes a model baseline? That it makes an easy target for those who don't like macro? Do we have to officially denounce the Kydland and Prescott model? Please provide a definition! Also, I think it is obvious that one should not introduce non-clearing equilibria where they are not appropriate. The labor market is a clear case, but most markets of financial assets are not. It is a matter of being able to make a case why using this way of modelling a market is appropriate. People don't assume market-clearing because of some protocol, but because it simplifies the math and, in many cases, it is not important to what the model wants to study.

      4. Being a victim of government paternalism that protects me from my irrationality, I am not smoking what you are implying. Maybe I should move to Washington also. The implication of the vN-M theorem is that the conditions needed to legitimize the representation of consumer choice as the outcome of utility maximization are not that restrictive or crazy. Even Gintis, last time I interacted with him a while back, seemed to be on board with the idea of representing consumers as maximizing some objective function. His issue was figuring out what should go in that function, and there the sky (or the math) is the limit.

      5. Being indifferent between two bundles does not make them identical. It means that the utility lost from not choosing one is equal to the utility gained from choosing the other, which introduces arbitrariness in choice if everything else is also equal. I would call that being torn.

      6. I would accept this, if your criticism was properly directed. But your portrayal of macroeconomic models as being similar in terms of the properties of equilibria, with a few exceptions here and there, is simply inaccurate and misses a lot of important work, too much to even site. Moreover, I fail to see how most of your criticism applies to macro but not micro. Most importantly, you have not provided any evidence of how consequential the assumptions that you don't like are. There are alternative frameworks, which I cited in my previous reply. The Nelson and Winter framework incorporates much of the things you mention, by using routines that allow for deviations from optimality and are consistent with the view of firms as organizations rather than single-minded entities. The problem is that this framework, while being more complex (which is why it relies on computational methods), has not yet contributed much to our understanding of macroeconomic phenomena relative to the existing framework. If you want to be useful you can work within this evolutionary framework and show that, yes, profit maximization, stability, whatever is a poor methodological choice and, look, if we instead adopt a different mechanism we get better results. This is how science progresses. Sitting at the sidelines, eating your pop corn, and criticizing those who are playing the game for not making the right moves may be the easy thing to do, but frankly, it gets old pretty quickly.

      Anyway, a roommate of yours from grad school tells me you are a nice guy, so I apologize for being too hostile in my previous remarks.

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    4. Anonymous8:32 AM

      "Do we have to officially denounce the Kydland and Prescott model?"

      Yes, that is generally the definition of science.

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    5. Anonymous8:49 AM

      I.e., that there exist models of whatever incorporating whatever is a sign of a total failure, not success. If you are to implement a policy, you have to use one model in order to evaluate it. If not even economists, not even approximately, can say what the current state of the art is (and keep themselves from defining it as X and not X simultaneous) - the whole project is completely useless (at this stage at least).

      I.e. economists cant go around and claim stuff, often by reference to economic theory, and at the same time keep themselves from criticism by simply stating that there only exist individual economists with personal theories, no economic theory.

      Maybe there should be more well defined schools of economic thought.

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    6. Anonymous9:27 AM

      PS: I started a thread on econjobsrumors in order to se if anyone can tell me wheter economic theory exist.
      http://www.econjobrumors.com/topic/does-economic-theory-exist

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  7. On the contrary, this is a terrific post. It is also par for the course for Professor Dorman. As a layman, I enjoy reading your posts, Peter, as they tend to be clearly written and understandable while making sophisticated arguments. I would highlight Point 5 as being particularly important. Accordingly, I think economists would do well to accept that their field is properly a social science. But they have a lot of work to do to meet that standard. :-)

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  8. Hi prof. Smith,

    I'd like to "return" to one of your blog posts namely that one:

    http://noahpinionblog.blogspot.com/2013/07/is-interest-rate-on-reserves-holding.html

    As it is well known, commercial banks don't have influence how much reserves there is in the system, as it is explained here:

    http://www.forbes.com/sites/bobmcteer/2013/05/22/bank-reserves-a-hot-potato/

    Bank can't "lend out" reserves:
    http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf

    So what's the point in deliberating this subject. As I understand it banks can only "change" the status of reserves from excessive to required (or push it to other bank). Both of them give the same interest rate.

    Am I thinking about something in wrong way??? (Thx for the answer in advance.)

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  9. scepticus4:53 PM

    Path dependency, and by extension, irreversibility, is IMO the most under appreciated and under studied, yet most important aspect of economics.

    After al,l it bears down with crushing weight upon all other aspects of our existence.

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  10. Anonymous4:58 PM

    I do wish the people behind EMH would look at a few of the accounting identities that their son-in-laws like to trumpet out of context.

    Financial markets are always going to have large elements of irrational behavior if they are trying to allocate money for which there is no rational investment. The world is awash in excess savings, and if any market suddenly provides the illusion of a safe reservoir, because of innovation or political exploitation, that money will rush in regardless of the underlying fundamentals.

    Too much savings and nowhere to save it.

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