Like the vast majority of econo¬mists, I was delighted to see Richard H. Thaler get the Nobel Prize in economics this year. Anyone with a bit of sense — a group that, believe it or not, includes many economists — knows that people aren't perfectly rational. But the assumption of hy¬perrationality still plays far too large a role in the field. And Mr. Thaler didn't just document deviations from rationality, he showed that there are consistent, usable patterns in those deviations.
The question, however, is how much difference this should make to the practice of economics. And here you have a division between two camps. One says imperfect rational¬ity changes everything; the other that the assumption of rationality is still the best game out there, or that it at least sets a baseline from which departures must be justified at length.
Which camp is right? My thought: It depends on the field, for reasons not entirely clear to me. Let me talk about two fields I am reasonably familiar with: macroeconomics, which I think I know pretty well, and finance, where I am much less well-informed in general but am pretty familiar with at least some international areas. What strikes me is that vaguely Thalerish reasoning is hugely important in one, and in the other not so much.
Let me state two propositions de¬rived from the idea that people are perfectly rational:
1.Rational investors will build all available information into asset prices, so movements in these prices will be driven only by unanticipated events; that is, they'll follow a ran¬dom path, with no patterns you can exploit to make money.
2.Rational wage- and price-setters will take all available information into account when setting the price of labor and goods, implying that demand shocks will have real effects only if they're unanticipated — in particular, that monetary policy “works” only if it's a surprise, and can't play a stabilizing role.
Now, the first proposition is basi¬cally the efficient markets theory, which we know is wrong in the de¬tails; there are lots of anomalies. In international finance, for example, there is the well known uncovered in¬terest rate parity puzzle: Differences in national interest rates should be unbiased predictors of future chang¬es in exchange rates, but in fact turn out to have no predictive power at all. And anyone who believed that the rationality of investors precluded the possibility of massive, obvious mis¬pricing has not had a happy decade.
Yet the broader proposition that asset price movements are unpre¬dictable, that patterns are subtle, unstable and hard to make money from, seems to be right. On the whole, it seems to me that consid¬ering the implications of rational behavior has done more good than harm to the field of finance.
What about the second proposi¬tion? That's where the economist Robert Lucas came in: trying to rationalize the observed facts of business cycles with perfectly ratio¬nal behavior in the face of imperfect information. This approach had a huge effect on the practice of macro¬economics, at least academic macro¬economics. But at this point we can safely say that it took the whole field down a rabbit hole. Wage- and price-setting does not reflect the best available information about future monetary policies.
So, rationality is a lie. But in some areas of economics it seems to be a bit of a noble lie, useful as a guide for thinking as long as you keep your tongue firmly in your cheek. In other areas, however, it's just a disaster.
As I said, I can think of some rea¬sons. In financial markets, smart in¬vestors can, within limits, arbitrage against the irrationality of others. There's no equivalent in labor and goods markets (or in consumer be¬havior!). But in general, the uneven applicability of behavioral thinking is surely — of course — a subject for future research.
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