Rationality, markets and crises

The homo economicus model of rational agents, acting to maximize utility in the possession of all available information, is not realistic. It is hardly a credible way to look at human beings, but we tolerate it because it is simple enough to allow equilibrium analysis which often gives reasonable predictions.

Illustration: Jayachandran / Mint

However, these equilibrium models are not serving very well in today’s situation. Standard monetary policy and (to a lesser extent) Keynesian theories are based on rational-actor assumptions. They give broad recommendations about monetary loosening and fiscal expansion. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do not follow the rational-maximizer formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky “rational actor with bits" instead of forming a coherent model.

The best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So, current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a good description of what we see.

Models of bounded rationality vary basic assumptions of the rational-agent model differently. Some of those assumptions are: 1) Utility is discounted over time in a consistent way; 2) people have access to all relevant information; 3) all relevant information is expressed through market prices; 4) people can instantly weigh the change in utility given by any buying or selling decision; 5) people act to maximize their utility.

Therefore, the typical way to create a bounded-rationality model is to relax one or more of these criteria.

The first class of model explores different time discount rates. Experiments show that people apply a high discount on utility in the present—they prefer £100 now to £120 next year—but a lower one in the future—they prefer £120 in four years to £100 in three. This, arguably, contributes to explaining recent huge variances between overnight and three-month interest rates.

Perhaps our psychological instincts reflect a pragmatic sense of the risk of a promise not being fulfilled, and the modern financial system has evolved to provide a confidence in the future that does not come naturally. If so, then the financial markets are no longer successfully filling that role. This short-long imbalance is an important cause of disappearing credit.

A second kind of bounded rationality reflects the idea that people do not have access to all relevant information. Many agents, short of crucial information, have had to make guesses. Clearly, this has led to many of the write-offs we have seen in the last 15 months.

A third approach relaxes the constraint that prices express all the information needed to make decisions. This classical assumption works only when there is a sufficiently liquid market, with defensible property rights. If enforceability is at risk (for instance, when there is a significant chance of bankruptcy), then we can use derivatives or insurance to provide secondary price information about the risk of default. If the market for these derivatives is not big enough or does not trade publicly, we lose that price signal. In these situations, we need to use non-price signals to make economic decisions, and we do not have good models for interpreting those messages. This leads to inconsistent or irrational decisions on resource allocation.

A fourth model removes the assumption that people can make an accurate calculation of the utility that a decision will provide. The concept of anchoring or habit—which suggests that we rely on familiar choices to avoid the mental effort and risk of picking alternatives is an example. This behaviour can be seen in the credit markets, where an aggressive conservatism appears to be in control of lending decisions.

The fifth alternative to the rational model is to ask what happens if people do not act to maximize utility. Indeed, is there any single quantity called utility?

Whichever model of behaviour is assumed, policymakers should ask what the models indicate for macroeconomic policy. No doubt the old solutions will work, given enough time. Today, with a much better understanding of economic behaviour, we could design more sophisticated solutions that would work faster.

A clear example comes from the concept of anchoring. Anchoring creates a tendency to fixate on one option for too long when we might profitably switch to another—it limits the effects of all kinds of quantitative changes in policy. If a bank is scared to lend at a spread of 2.5%, anchoring implies it is unlikely to start lending when the spread increases to 3% or even 4%. This demands a qualitative change in conditions so that the bank can no longer make a simple marginal comparison but is forced to re-evaluate its returns from scratch.

Given such arguments, it is better to enter the recession sharply—even at the cost of a big immediate reduction in gross domestic product—if it creates an expectation that we have hit the bottom. When people believe it can only get better from here, they will act accordingly—investment and spending will start.

The paradoxical conclusion is that it may not matter what new institutions or new rules are designed—as long as something is done. Any new framework gives agents a reason to abandon their anchor to fear, and gives them a chance to reattach themselves to hope. This—the converse of Keynes’ paradox of thrift—is what will rescue the world economy.

Edited excerpts. Printed with permission from VoxEU.org. Leigh Caldwell is chief executive of Inon. Comment at theirview@livemint.com

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