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.

Berlusconi Steps Down

The NY Times describes a great scene from this past Saturday:

An impromptu orchestra and choir gathered outside the presidential palace, where Mr. Berlusconi resigned, playing the “Hallelujah” chorus from Handel’s “Messiah.”

Hundreds of spectators gathered outside, shouting “buffoon” and “go home” to a polarizing leader once loved by many, making Mr. Berlusconi the very embodiment of the Italian saying that the tenor is applauded until he is booed off stage. Some in the crowd were popping bottles of champagne. And cars and mopeds in downtown Rome waved Italian flags and honked their horns in celebration, as they do when the national soccer team wins.

It would have been exciting to be there. Of course, a change of prime minister doesn’t change the financial and economic environment in which Italy finds itself. We now have two Marios, Mr. Monti and Mr. Draghi, to watch for the next stage in the euro debt crisis.

“I know that the crisis won’t be over just because he leaves, and I’m a bit concerned about what will happen with the markets, but I know that this country will be better without him,” said Isabella La Monica, a retiree, who was waiting in front of the prime minister’s residence. “Things can’t get any worse.”

We’ll see about that.

No Winners in Debt Debate

Here is an excerpt from an interview with Bob Dylan I recently read in which he answered a question about politics.

Q: What’s your take on politics?
Dylan: Politics is entertainment. It’s a sport. It’s for the well groomed and well heeled. The impeccably dressed. Politicians are interchangeable.

Thats pretty much exactly what the debt ceiling debate amounted to – a sport, a competition. The debate polarized into a competition with a clear winner and loser. It wasn’t as if one side wanted a 5% increase in taxes and the other side wanted a 10% increase and they were going to eventually going to agree at 7.5%. The republicans stated that they wouldn’t accept anything that constituted an increase in tax revenue and the democrats said they would only accept a balanced approach with both more revenue and lower spending. That meant there was a clear winner and loser – either there was more revenues and the Democrats were going to win or there wasn’t any more revenues and the Republicans were going to win. Sadly, the debate focused so much on the egos of both sides winning and losing that there was hardly anyone who spoke of the future of the economy and how to pass the bill in a way that would be most conducive to future changes in technology, business and education.

Thomas Friedman wrote last week in an Oped in the New York times,” What business do you know — that is still in business — that would operate this way: making massive long-term cuts, negotiated by exhausted executives, without any strategic plan? It certainly wouldn’t be a business you’d expect to thrive.”

Boehner said he had forced Obama to give up his initial demand for a “clean” borrowing increase — one without anything attached — as well as his later call for a “balanced package” that included revenues as well as spending cuts to shrink the deficit. The deal, Boehner said, is all spending cuts and has nothing that violates Republicans’ principles.

The republicans declared victory and showed they could push Obama around. However, with no strategic vision, everyone is losing out.

Planet Money Comes to DC

Last night, NPR’s Planet Money came to DC’s Sixth and I Historic Synagogue for a live event and taping.

Alex Blumberg and Adam Davidson, interspersed with pre-recorded interview segments,
painted a picture of two coexisting US economies: the “broken” economy and the “American dream” economy. In their trademark style, they discussed how the growth of the knowledge and service economy have increased the value of education, resulting in a bifurcated American experience for those with advanced degrees and those without.

I won’t go too much into detail as the event will serve as their podcast this Friday, but suffice to say that, in their slightly tongue-in-cheek view, the US economy could be fixed in three simple steps:

1. improve access to preschool education – this is the key age for the soft skills required to excel in today’s economy (see Dr. Heckman)
2. bring national debt back under 90% debt:GDP – we don’t need to eliminate the debt, nor should we try, in order to restore fiscal sanity
3. replace employer-based health care with anything else – it’s a strange beast, and almost any other system would be better

In the face of how our issues relatively aren’t that severe, how any harm would be almost completely self-inflicted, and how solutions are in reach, they said that our “problems really are Jersey Shore problems”.

I was able to thank Alex and Adam afterward for setting the stage for Recession Sessions nearly three years ago by featuring a rough cut of Central Banker’s Dilemma on their podcast.

Make sure to tune in Friday to Planet Money for the whole show!