Rational behaviour?
Economics is a bit of a mixed bag. Part science, part psychology and, many of us might suspect, a fair bit of guesswork as well. Economists do a great job of telling us what has happened and why, but their predictions of the future often fall wide of reality.
Part of the problem may lie with economic orthodoxy that assumes people are rational, selfish and independent economic agents. Economists expect people to act in a way that provides them with the highest economic gain. Yet when we look at the real world, there’s plenty of evidence that this isn’t the case.
Many people happily gamble large amounts of money, even though any rational analysis reveals they are almost certain to lose. And contrary to being independent and selfish, psychologists have demonstrated that most people are willing to share with total strangers, even if this is detrimental to their own financial position. This may surprise economists, but to biologists this probably makes sense. We are a social species, and trusting others is an important part of the glue that holds our society together. However, in complex societies too much trust can be a bad thing.
Take the current credit crisis. The sub-prime mortgage market was developed by financiers who used complex mathematics to calculate the risks attached to the mortgages. These were then packaged up and sold to traders who didn’t really understand what they were buying. They worked on the idea that if the clever people who developed these products thought they were valuable then that must be the case. Now the situation is reversed. Trust has evaporated to the point where banks are unwilling to lend to each other.
Share markets provide another example of real behaviour deviating from economical ideals. Efficient market theory is founded on the idea that markets act rationally to the release of new information. Yet recent studies have found that few jumps in share prices were linked to any news, and most news releases didn’t cause any changes in share prices.
Further mathematical modelling showed that the price of a share remained remarkably stable if, in line with theory, traders responded to news and acted independently upon it. However, a resemblance to real market behaviour only started to emerge when the model allowed for copying between traders. When copying reached a threshold level, prices spiked then crashed. Sound familiar?
So what is the average investor to make of recent economic outlooks from some of Australia’s largest financial institutions? The consensus seems to be that interest rates will fall, the oil price will drop from its record high but increase over the long term, and share markets should start to recover by mid-2009. No doubt there are sound, rational reasons underpinning these views. The question is, should we trust them?
Sources:
Lunn, P. What me, irrational? New Scientist. 30 August 2008
Buchanan, M. Why economic theory is out of whack. New Scientist, 19 July 2008