The Rational Actor

Last night I had the opportunity to hear Greg Ip, US Economics Editor of The Economist, speak at the Chicago Council on Global Affairs. He had some great insights on the current state of the US economy and what that might mean for globalization in the coming years. He seems to hold some refreshingly idiosyncratic views of the causes of and lessons learned from the Great Recession, and while I don’t agree with all of his conclusions he was a very articulate and engaging speaker.

One issue that I think he and many others unfortunately get wrong revolves around the economic concept of the rational actor. In many people’s telling, neoclassical economics stands or falls on an idea of market participants making completely logical decisions. Since humans clearly aren’t logical, standard neoclassical economics, if not all of economics, must be wrong from the starting gate. Mr. Ip took the recession to demonstrate that actors aren’t rational, and also that the recession itself stemmed from this irrationality.

Firstly, in economics, “rational” doesn’t mean the same thing as “logical”. To assume that people act rationally merely means that we can assume that they make choices, based on the information that they have, that increase whatever resource they want to increase. It isn’t a claim that Vulcan-like disinterested logic rules the day, which would be absurd on its face. Unfortunately, the idea of a rational actor tends to be a flimsy straw man that serves no real purpose above a cheap joke against economics. Mr. Ip knows this, and I don’t think it was really the point he was trying to make, but since so many people do try to make this argument, it’s worth stating.

What Mr. Ip does miss by blaming the crisis on irrationality is a more profound and perhaps more sobering picture of what we can learn from the recession. I think it is naive to pin the recession on people acting stupidly. It can make you feel good, pointing to the stupid people in hindsight, and feel confident that you would never make what in hindsight turned out to be bad mistakes. Similarly to blaming violent crime on “monsters”, blaming the recession on irrational actors really just serves to create an “other”, where if only it weren’t for that “other” nothing bad would have happened.

The crisis, instead, happened despite people acting rationally. It is rational (in an economic sense) for a potential homeowner to purchase a house with no money down if a bank will cover the mortgage. It is rational for a bank to give more and more risky loans if investment banks are willing to get them off their books in return for a nice fee. It is rational for investment banks to be willing to buy more and more risky and complicated assets if they can be pretty sure that they won’t be the ones holding the hot potato when the game is over. And it certainly is rational for investors of all stripes to assume more risk if there is a reasonable expectation that the government will socialize any major losses that occur.

The real danger with our current economic system isn’t that it allows irrational people to make bad decisions, it’s that enormous crises can result exactly because it’s in everyone’s interest to keep the party going, enjoy the ride, and allow the taxpayer to clean up afterward.


“On October 30 2008, I took the opportunity to deliver a pep talk to my staff, just before we began a lengthy strategy session in which I would lay out the assignments for the next few days. And of course everyone already expected they they were going to work all weekend. That’s what we did. I had to fly to Chicago with Wendy to babysit our granddaughter – but I, too, knew I would spend most of the weekend working.”

This quote is from From Hank Paulson’s memoir On The Brink. Many people have had problems with various policy decisions related to the handling of the financial crisis and there are still many unanswered questions. A very simple question I’d like to ask is why did the Treasury Secretary have to go babysit in Chicago while the financial system was on the brink of collapse?