Z-Fallingwater

New Paternalism at Cato Unbound

Cato Unbound is hosting a series of essays dealing with New Paternalism. The lead essay comes from Glen Whitman, an academic arguing from the libertarian position, and Richard Thaler, one of the leading scholars in behavioral economics (as made famous in this book) is set to respond tomorrow, the sixth. I am anxious to see how Thaler, a rare left-ish economists working at the conservative environment of U Chicago, responds to these subtle objections.

For a recent NYtimes article from Thaler, see this (I am unimpressed by that analysis for more reasons than those presented by Whitman above).

For what basically amounts to a video version of Whitman's lead essay, go here.

Fear the Boom and Bust Cycle

The following... hip hop video...  has made the rounds on pretty much every libertarian or conservative outlet out there in recent weeks, but I feel the need to acknowledge it here as well:

It is remarkably accurate and comprehensible for the layperson. The position of its creators is unambiguously in favor of Hayek, but a Keynesian has little reason to complain.

More of Krugman's Propaganda

Krguman has been the most outspoken supporter of the stimulus package among economists in academia, sometimes going as far as saying that the already enormous price tag will fall short of what is needed to achieve full employment. While Keynesians such as Krugman use several different arguments to justify an increase in government spending, Krugman leans exclusively on the liquidity trap.

The liquidity trap is a theoretical situation where the Fed is handcuffed because interest rates are approaching zero. Besides the recession today in America, the most famous example of this phenomenon is Japan's sluggish economy since the early 1990s.

Author economists have argued that the liquidity trap is irrelevant and a red-herring. Scott Sumner, for example, has argued that the problem is a deflation that resulted from a decrease in the speed each individual dollar moves across the economy (agreeing with Krugman) and that the only thing we need to do is to print more money (disagreeing with Krugman). Technically speaking, he argues that the Fed should target a set increase in nominal gross domestic product, which will automatically neutralize deflationary pressure. For Sumner, the interest rates are an incidental byproduct of the traditional methods of monetary policy, not the driving forces of the recession.

Sumner has received a great deal of press with the growing popularity of his own blog, The Money Illusion. Krugman, this Friday, has seemingly finally acknowledge the existence of Sumner's argument, to which he responds with more boilerplate emphasis on interest rates that doesn't actually discuss Sumner's (or anyone else's) rationale for the dictum, PRINT MORE MONEY.

He concludes with an offhand remark that the case for the fiscal stimulus is "really clear" and a link to another blog post. Okay, I'm interested in seeing a concise justification telling me why a fiscal stimulus is the only option... I click the link. And what do we get? A quick blog post mentioning a fully worked out New Keynesian model of the economy, one which Krugman acknowledges "was written in a hurry, so it’s surely incomprehensible to readers who don’t know the New Keynesian Economics literature, and probably incomprehensible even to those who do." He then restates the boilerplate, that "when monetary policy is up against the zero bound, the optimal fiscal policy is to expand government purchases enough to maintain full employment."

I clicked through the link to the paper and can say will full certainty that less than one half or one percent of Krugman's readership would understand it. I'm a first year PhD student studying the methods Krugman is using, and I have to stare at it for quite a bit to understand the model's assumptions. And this is the "really clear" justification for the fiscal stimulus? I mean, really? Krugman has been writing articles arguing in favor of a stimulus for more than a year, and what he chooses to provide as an intuitive response to someone like Sumner is incomprehensible model building? What does he expect from someone actually willing to follow him down his rabbit hole of hyperlinks? It's almost as if he's cognizant that as emperor, he has no clothes, and needs to throw complicated math at the masses (which is "really clear") to distract them from seeing that.

Even if we lived in a world where everyone has a strong grasp of control theory and differential equations and could understand the gist of the model, the model itself means nothing in this context. The purpose of models is to describe, and to describe they need to make assumptions. But different assumptions are exactly why someone like Sumner disagrees with Krugman. Krugman makes the most classic and worst mistake economists have a tendency of making, which is to assume what you are proving in order to prove it.

When Krugman pulls this type of stuff, he is no longer an economist. He's an ideologue and a propagandist. George Soros coined the snarky term "free market fundamentalism" to portray those arguing against government as holding a religious belief in favor of markets in the face of mounting evidence. While occasionally this may hold water for certain elements of the free market crowd, Krugman's harm as a propagandist far outweigh the harm caused by mediocre financial advice. He deserves the label "fiscal fundamentalist" until he begins to discuss criticisms in a less dishonest manner.

Challenge to George Soros

George Soros recently announced his $50 million investment in a new think thank, the Institute for New Economic Thinking. At least one blog has already sniped Soros for the ironic name of the institute, since its advisory board is an allstar list of economists ensconced in the left/center-left consensus. Soros's belief that more regulation is necessary and will not tend back towards full employment without the help of government intervention is not any newer than Keynes (and in truth Keynes merely popularized unpopular ideas than say anything new). His belief that recent decades are a testimony against all "market fundamentalism" is both an oversimplification of vastly different arguments in favor of capitalism and a misreading of what began the return to freer markets.

Coming out of World War II, planning was the name of the game in Western political economies. Soviet Russia wasn't some supreme failure as we now understand it to have been; most intellectual circles saw it as a more efficient, rational economic system. That, paired with seemingly utopian Old Keynesian Economics, brought forth a rapid expansion of the role of government in the West from the end of the war to the 1970s.

It's easy to forget (or not even learn) how extreme Old Keynesians were in their belief in the power of fiscal policy. While the mantra of the free market Chicago School has been that (paraphrasing), "the level of employment is inevitable, and the only thing you get by printing and spending money is more inflation", Old Keyensians actually believed the opposite, that the level of inflation is inevitable and the only thing you get by printing and spending money is more employment". While Soros may hate "market fundamentalism" in all its forms, especially the Chicago School, even he and his advisory board (hopefully) recognize that one of these statements is much sillier than the other. As a result of decades of policies "informed" by Old Keynesian beliefs, we got the stagflation of the 1970s, something that Old Keynesians believed to be literally impossible. The Chicago School gained credibility and the left moderated into a retrenched New Keynesian School.

The Chicago School and the New Keynesians now constitute the right and left of mainstream neoclassical economics. Both schools, unfortunately, do share a predilection for making very strong assumptions about the rationality and knowledge of human beings when conducting themselves on the market. If the free market were only "proven" by models which made such assumptions, I would be in full agreement with Soros. I am, in fact, inclined to agree with him broadly that those assumptions need to go and that the fields of behavioral economics and behavioral finance are fruitful in loosening these assumptions.

However, in speaking of market fundamentalism, Soros acts like these two schools are the only (or even important or primary) economic justifications for the free market. Namely, New Institutional Economics, the Austrian School, and Public Choice all provide strong justifications against government intervention without invoking a perfectly efficient and well-ordered market beforehand. The uncertainty of all human action is a cornerstone axiom of the Austrian School, while Public Choice Theory does nothing but call into constant question the actions of the government by merely suggesting that public officials and civil servants are no less motivated by self-interest than those in private firms. New Institutional Economics shares more with the Chicago School, but it ultimately focuses on providing an institutional framework that will make the market work best, rather than assuming any free market framework at all will lead to an economically efficient outcome.

Today's deregulated economy did not come from any particular embrace of the Chicago School or one of these other free market schools of thought, but from a rejection from the statist mid-century economic doctrines of Old Keynesianism and economic planning. These deregulations did not go much further than what was prescribed by rejecting what had clearly failed. If Soros wants to truly provide new economic thinking, he should not be paying a bunch of PhDs to come up with new justifications for old statist policies. As I discussed in my review of Animal Spirits last month, pretending to break ground in economic thought in order to justify ultra-specific policy remedies (i.e. Keynesian fiscal spending) does not give you any credibility whatever.

Instead, and this is getting back to that review again, Soros should start with where mainstream economics is wrong theoretically and moving from there. If we want to drop the rationality assumption non-selectively and non-arbitrarily, we should start with the behaviors cognitive psychology has proven are embedded in the human psyche before asserting the "money illusion" once more. That, in essence, is my challenge to Soros: if you want to tear down the edifice of modern economics, start at the theoretical level and go from there. Anecdotes of greed or irrationality shouldn't influence theory. Proven deviations, like Monday Morning Quarterback, should be where new economic thinking should begin. What systemic changes can we make to the market which protects us overconfidence or confirmation bias? To what extent do they interplay with the selfish motives of individuals, since these biases only work contrary to them? If we want a new economic system intrinsically different from the four or so models that everything else boils down to (Capitalism, Socialism, Keynesianism/Interventionism, and Mercantilism), what is that to mean. And if Soros, who really should be pursuing this given his stated goals, is able to achieve funding such a new theory, it would be a worthy use of his money.

It's Never an Empirical Question

One cliché among seemingly all economists I find infuriating is, “it's an empirical question.” By this, it is generally meant that the economist has encountered a situation where he or she has found two arguments to be theoretically sound and cannot scientifically choose between them. One plausible “force” goes in one direction and another goes in the opposite direction; the only way to find out which "wins" overall is to look at the data.

To this, Post-Keynesian economist Ronald X. Chase replied,

“An uncertain and ambiguous situation like this arises in a discipline such as economics for various reasons, the most important being the 'softness' of data and questions of interpretation of test results. Thus, for example, whenever hypothesis are not confirmed, it can usually be argued that the data required (additional) information, or that other data should have been used, and/or that the ceteris paribus assumption was violated due to 'exogenous' events which in turn require that additional or different assumptions be 'ad hoc'ed' onto the test model, and so forth. Thus, it happens that seeking refuge in the logical-positivistic argument that empirical outcomes are all that matter, not only begs the question, but is itself a metaphysical rather than a scientific position. As a salient example of this, [neoclassical economist C.E.] Ferguson, after calling for econometric testing, so as to determine the validity of the Cambridge criticisms of neoclassical production theory, went so far as to state that 'Until the econometricians have the answer for us, placing reliance upon neoclassical economic theory is a matter of faith. I personally have faith; but at present the best I can do to convince others is to invoke the weight of [Paul] Samuelson's authority.'

“Metaphysics, as we have noted, plays an important and, in the Schumpeterian frame, a necessary role in the pre-analytic state of theory formulation. However, its constructive utility at the later level of supposedly scientific explanation is an entirely different matter. Metaphysics was never intended to be a device for (theoretic) crisis management!” (from pages 78-79 of this book)

Empirical testing, even done properly, rarely solves anything, especially when an issue is contentious enough for an economist to give up and declare it an empirical question. Macroeconomists have been sitting around for the last forty years staring at data trying to figure whether the aggregate supply curve is a vertical line or an actual curve to little avail, given the enormous disagreement that remains in academia on that point. And since the answer to that one question would tell us immediately whether Keynesian economics is true or not (meaning, whether a stimulus could help) , well, you get the gravity of the situation just from that.

Actually, I think the inanity of declaring certain issues “empirical questions” is even worse than Chase suggests above. In truth, any economic question is an empirical question. After all, the only difference between the theoretical assertions of a neoclassical economists and those of a Marxist economists are the a priori assumptions going into it. In these situations, you have four options

1. Declare one of the arguments stupid.

2. Declare one of the arguments evil.

3. Declare it to be an empirical question.

4. Accept either position as true so long as the assumptions going into its conclusions are true.

I prefer 4. Unfortunately, it's not “scientific”, but at least it's epistemically sound, which is more than you can say about the sociological outcomes of empirical questions.

I think it's also fair to stress something that Chase mentioned in passing- that declaring something to be an empirical question is intrinsically a logical positivist position. In other words, such a declaration assumes the precepts of a philosophy of science that has been dead for decades. I will give it credence to the extent that I give credence to an assumption that logical positivism is true, which is to say that I find it extraordinarily unlikely.

At the same time, I'm unconvinced that economists are really that big into extolling the virtues of logical positivism. When declaring certain issues “empirical questions”, they aren't really saying anything at all, since by the standards of logical positivism, everything is an empirical question. What they're really saying is just a fancy, pretentious way of telling you that they don't know, or that they would prefer not to argue anymore (making “empirical questions” no more than a thought-terminating cliché, which is something I find perfectly believable). Life isn't so simple that we can hope to resolve ambiguities by throwing everything into a regression and seeing what pops out. Hiding behind a veil of pretend science doesn't help when what we should really be doing is better understanding one another's arguments.

Book Review - "Animal Spirits"

I was really looking forward to reading this book. Despite my unkind words for one of the authors (Robert Shiller) in an earlier post, I found his “Irrational Exuberance” to be very persuasive. It made me reject Efficient-Market Hypothesis -the idea that all stocks reflect all information publicly available to the market- without much reservation. Shiller was extremely meticulous and careful in defending each point he made, setting everything up so it seemed pretty much impossible not to agree with him [sidebar: I actually think “The Misbehavior of Markets” by Mandelbrot and Hudson even more conclusive regarding the issue, if anyone is interested]. Shiller, despite the strength of his argument, was even more careful in providing policy prescriptions.  His recommendations boiled down to two suggestions, that economists and other officials in places of power (like the chairman of the Fed or the president of the U.S.) shouldn't entice over-confidence and that we shouldn't institutionally discourage shorting so that there is more downward pressure on prices during a bubble.

Background: "Animal Spirits" is a term created by the most influential economist of the 20th century, John Maynard Keynes. He famously asserted ,

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

In context, he meant that irrational emotions ("animal spirits") controlled the amount of investment that entrepreneurs were willing to gamble. This argument has generally fallen out of favor among mainstream and center-left economists, who now generally make arguments about the limits of the efficacy of monetary policy as a result of the liquidity trap.

I understood, going in, that I was going to be reading an interventionist-leaning book. What I thought was that, given Shiller's (in my mind) credibility and (Nobel Laureate) Akerlof's pedigree, that the titular "Animal Spirits" were carefully chosen cognitive biases that have very strong scientific backing. Namely, confirmation bias, hindsight bias, prospect theory, or similar ones. These are biases embedded in the human psyche in ways that the species may never get around. I could see that. Despite my free market sensibilities, I was very much open to regulating them, especially if they could regulate biases in such a way that would deflate business cycles.

The book doesn't deal with anything resembling them. Instead, it provides a list of "animal spirits" the evidence for which is anecdotal, open to interpretation, and usually both. These animal spirits are then used to argue in favor of, of all things, Keynesian economics, whose messaged eventually becomes the central message of the work.

Keynesian economics is ubiquitous. When you hear people say that the government needs to create jobs, it's Keynesian economics. When people say that we need more liquidity, it's Keynesian economics. When you hear that we need a stimulus, whether it's "conservative" tax cuts or "liberal" spending, it's Keynesian economics. As I said earlier, the current debate of why the government should do either and how that creates jobs is (normally) about the liquidity trap. In the interest of hypothetically remaining impartial, I'm going to set that aside. The authors' justification for deficit spending has nothing to do with that. Their argument is the money illusion.

The money illusion states that people focus on the nominal level of their wages instead of their real wages. Meaning, they like the idea of wages increasing even if the price of goods has increased with it. It also means they freak out and refuse to work if their nominal wages decrease in conjunction with a justified decrease in the price level, therefore creating unemployment. This reaction is irrationality, an animal spirit, according to the authors.

The incredibly academically dishonest step the authors make, however, is asserting that this is the context in which Keynes coined "animal spirit". He referred to this effect in "The General Theory", but only in the response of labor unions during economic downturns, which was perhaps reasonable. Labor unions had little idea that prices were falling during the Great Depression and felt justified in maintaining wages. This wasn't unjustified given the information they had at the time. Keynes's plan was, in the event that this happened, to increase the price level so that merely maintaining the union's nominal wage would effectively decrease the wage in real terms, allowing the employer to hire new workers at what their real wage rate really should be. Keynes didn't refer to it this as an "animal spirit" (look it up in "The General Theory"!), and he shouldn't have. This problem was the ignorance of workers, not the irrationality (animal spirits) of workers. Keynes would be remiss to call it that, and he didn't in his greatest work. Shiller and Akerloft may be correct in describing this effect as something detrimental to unemployment, but they are flat out lying when they refer to it as the animal spirit Keynes talked about. It only makes me think that they are trying to both lean on the Keynes's cachet while dodging a fundamental dismissal of his original argument.

And boy do they ride on the cachet of Keynes's "original meaning." At one point, the authors refer to the the late 1960s when Milton Friedman's free market interpretation began to take hold among economists. I'm not going to begin discussing the technicalities here because I don't want to surpass the 3,000 word threshold, but what Shiller and Akerloft do in response to Friedman's rebuttal is absolutely obnoxious. They go through his argument, accept that it must be somewhat right, and state that we should go somewhere in between, which is perfectly reasonable. What they then do is to tacitly take up the Keynesian argument once more, completely ignoring Friedman's analysis. The scene, sadly is one that takes place again and again throughout the book. Shiller and Akerlof supposedly acknowledge the probative benefit of capitalism, and given that (and the loosest possible definition of markets), they take an extreme leftist point of view, especially from the standpoint of economists.

The strongest piece of evidence that they use to make this point (in contrast to surveys and conjecture) is a study which cataloged the consideration of inflation a sample of Canadian unions took when negotiating wages. Only a minority of these unions used any objective measure of inflation built into their wages, and many of them only did it to a certain extent, such as recalculating only when inflation surpassed an upper limit. This was the closest thing to a real market (rather than people describing the supposed motives for their behavior to a survey or a sociologist), I saw in "Animal Spirits", upon which we could actually make  an economically informed descripion.

And it fails. If we are to look at inflation as Friedman's metaphorical crates of money dropped down by helicopters, where everyone receives an increase in nominal income in accordance with efficient economic allocations, we have nothing to worry about. But they don't. Money enters the economy many different ways. One firm may experience a "typical" 3% increase for the cost of its inputs. Another may experience a 10% decrease. These "hypotheticals" aren't mere hypotheticals; perhaps the former is oil dependent and the latter is a call center which is in the process of outsourcing? A given uniom could well be negotiating based on the expectation of inflation with their own industry and in general, the expected increase in "general" price level could be effectively white noise. In that case (which I think is the most realistic one), we should expect linking wages to CPI to make sense rarely at all, and the extent to which the market does it only demonstrates its consciousness of inflation.

I'm not saying that my counter-arguments irrefutably condemn those proposed by Shiller and Akerlof. Instead, I argue that the best of what they have to say is intuition and innuendo contrary to the formal practices of economics. If the best they have to offer (and I know that they have other arguments in favor of Keynesian economics, but that this was the least ridiculous one), then why should they have credibility at all? In addition to their statements about fiscal policy, each and every one of their secondary arguments (social security, affirmative action) just happen to result in argument in favor of the left. Albeit, I haven't specifically taken on those issues or others in favor of limiting this post to length shorter than "Animal Spirits" itself, but it lessens one's credibility to so "scientifically" interpret selectively chosen pieces of evidence so that they all fall on one preordained side of the political spectrum.

Somewhat tellingly, the authors continually repeat how their point of view is so marginalized in academia and the big bad Chicago School (of which I'm not a member, FYI) blinds their fellow academics. If you go and read the goodreads reviews, approximately 100% (perhaps hyperbole) of reviewers of this book will act really confused and say that the only reason they didn't love the book was because they already heard these arguments in school. Which is to say, "Animal Spirits" isn't anything new. Keynesian economics has already been refuted (in all the important theoretical ways) by, at the latest, the time of Thomas Malthus. Perhaps at this point, I'm showing my ideological cards a bit to much and opening myself for justified criticism in dismissing fiscal intervention so broadly, but "Animal Spirits" doesn't say anything that you won't get by attending EC202 in a center-left school.

The authors also ask, why should we only consider rational motivations when there is so much else to inform us about human action? Prudentially, I would answer that we focus on the interests of the individual because, once you eliminate that, there are no limits to the sociological/psychological/philosophical/religious/whatever arguments you want.  We may inform our opinions based on those factors, but they do not become relevant until they relate to how individuals best allocate their resources to maximize the benefits they receive from them.

More passive-aggressively, I'll refer to a quote from baseball historian and analyst, Bill James.

All discussions have [bulls***] dumps; we need them. Our logic, whatever it is that we are talking about, can never be completely worked out; all subjects worthy of discussion are too complicated to be full encased in logic. Thus, in all discussions, the least precise areas become [BS] dumps, elements of the discussion which are used to reconcile our formal logic to our intuitive sense of right or wrong, justice of injustice, accuracy or inaccuracy, reason or madness, moderation or extremity. 'Psychology' is a common [BS] dump. I am not saying that psychology is not real or that psychologists do not know what they are talking about. What I am saying is that since human psychology affects almost everything within our sight in undocumented ways which are never full understood, psychology inevitably becomes a [BS] dump which can be used to justify or explain what is otherwise unjustifiable or inexplicable.

Book Review - "Money, Markets, and Sovereignty"

“Money, Markets, and Sovereignty”, released this year by Benn Steil and Manuel Hinds (both from the Council on Foreign Relations), provides an extensive yet unconvincing justification for both globalism and the gold standard. Polemical in nature, it methodically abstracts first to the Hellenistic philosophy of Stoicism before retracing the steps of free trade, the nature of money, and financial crises throughout history. It concludes with a thesis guaranteed to infuriate nearly everyone: globalism is essential to economic welfare, but it is completely incompatible with monetary sovereignty.

According to the authors, our public policy situation is unique in history. Never before has such an element of free trade ever been before combined with fiat money. The only other episode of extreme free trade, the Western world from the middle of the nineteenth century to World War I, was coupled with the gold standard. This situation brought with it the Humeian concept of the species flow; trade self-regulated with outflows and inflows of gold. Today we see a much different monetary situation, where everything is effectively linked to the dollar and everyone overseas holds the dollar because they don't trust their own government's fiat money. This is not a stable relationship and cannot last indefinitely. America's dollars have taken the place of gold in bank's around the world, and since the Federal Reserve can print as much as it wants, there is no feedback mechanism the market can use to determine the correct allocations of worldwide imports and exports.

There are a few nitpicks that do not necessarily hurt the authors' overall agenda, but render it far less convincing than it could be otherwise. Mainstream economic orthodoxy is ignored all too much. The international conception of free trade is largely dismissed, and they'll say things (paraphrasing, “floating exchange rates is the contrary to free trade”) that a typical economist would find absurd. They may then justify their statement, but they do not adequately demonstrate why the orthodoxy says what it says. In the course of discussing the gold standard and the Great Depression, they bring up Keynesian economics, oversimplify it as being unwarranted concerns about wage inflexibility or debtors being unable to repay debts in the face of deflation, and leave it at that. Again, this doesn't take away from the legitimacy of what they're arguing, but I do not see how they would expect to make inroads into academia and persuade moderates if they are more or less ignoring them.

Secondly, they use empirics rarely, and when they do, they use it very poorly. The handful of regressions that appear are all single variable graphs with blatant heteroskedacity (an econometrics issue which invalidates statistical significance). They didn't really need the graphs and the relationships they were discussing therein could have been explained intuitively, so I don't understand why they even put them into the book. They only detracted from their credibility.

Lastly, they overstated the degree to which the late nineteenth century was truly on the gold standard. The United States had nontrivial barriers for redemption, had a habit of regulating private banks out of existence, was off the gold standard altogether during the Civil War, dragged its feet when getting back on it, and ham-handed it when it finally did. To name just a few of its derivations. The Bank of England was a bit better, but it still had a functioning, regulating central bank which both monopolized the issue of notes and acted as a lender of last resort. This was not free banking. It was not really the gold standard. In fact, it was managed trade and managed (sovereign) monetary policy. The degree to which that is true then is far less than it is today, but it isn't quite as categorically different as the authors pretend.
I like this book, but that's probably only because I already accepted the thesis. Which means that the book is either A) an excuse for confirmation bias on the part of Austrian economists and like-minded goldbugs or libertarians or B) propaganda targeted at people who have not read that much on mainstream analysis of free trade and international economics. I'm inclined to think it's (A) both for the sake of the authors and because parts of it are too technical for a layman to understand 100% (or it's trying to obfuscate by doing so, which would be worse). (A) is still nothing to be proud. The fact of the matter is that this point of view is SO far off the map of mainstream journalists, politicians, and informed individuals that it can't possibly be taken seriously as something that will persuade them. You're not going to convince Ralph Nader and Patrick Buchanan that free trade is good because the Stoics said so, it's part of the classically liberal tradition, and a bunch of economists agree that it will increase general welfare. You're not going to convince the Democratic Leadership Council or free market republicans that we should blow up the Fed because of this interesting-but-weird historical paradigm you set it in (even if they understand what the hell you're talking about). And least of all are you going to convince academia, which will immediately see this style of argument (perhaps rightly) as the work of propagandizing ideologues. I won't blame any of them.

Economic Rationality

Rationality is a central postulate in mainstream economic thought. It allows economists to focus on the results of the choices of individuals by setting aside possibilities which are not indicative of the general essence of human action . Due to how individual “rationality” is generally defined, an understandable skepticism arises when economic models assume everyone acts in such a way; we all know some grandparent who stubbornly mishandles her money or a high school friend who can't help but to drink himself out of job after job. However, these decisions are not necessarily “irrational” in the accurately defined economic sense. Individuals can only be called irrational in the vernacular sense (that they make unwise or psychologically driven decisions). Unfortunately, some economists have misused the concept similarly as well.

Objecting to economists' use of rationality as the word is commonly understood is elementary: such use is unjustified assumption. By Occam's Razor, our analyses should limit assumptions as much as possible. Even so, this objection completely misinterprets what “rational” means (or should mean) for economists. Rationality means that human beings have goals and they act to achieve those goals. It's not necessarily true that their choices of how to act are accurate. Individuals are self-interested, in the sense that they want to fulfill the goals of themselves, not the goals of others. They are not necessarily selfish, in the sense that they care only about maximizing their pleasure (utility, in economics jargon). These goals could be anything, whether that constitutes getting in shape, putting food on the table for the family, educating one's self, watching a movie, or curing cancer. As defined, everyone is economically rational- the shrewed businessman as much as the child as much as the social worker as much as the sociopath. Rationality is not an unnecessary assumption. Rather, it's the description of human behavior that takes the fewest number of assumptions possible.

This has not kept some economists from myopically equating rationality with narrow selfish behavior. A popular example is Steven Levitt's bestseller, “Freakonomics.” Among other anecdotes, Levitt narrates the story of contemporary Sumo wrestling in Japan. Contrary to the tremendous social suasion encouraging the honor of the wrestlers involved, Levitt finds empirically that wrestlers may be colluding during certain fights so that the lesser wrestler is more likely to enjoy the greater relative benefits of winning the match. He does so by establishing that lesser wrestler wins more than he “should” given chance alone. What Levitt then zeros in on is the wrestler's inevitable selfish, or “profit-maximizing”, behavior. Levitt concludes that the “economic” interpretation of the data is that, on average, wrestlers act reciprocally to one another when these situations arise so that they may expect the same in the future. The author goes on to say to the effect that those who disbelieve his argument predicated on empirics and his rather fatuous form of rationality are mere plebeians tied an silly, outmoded upbringing and culture which are belied by his economic wisdom and scientific “facts.” In reality, there is no scientific rationale for seeing the empirical data that way, except Levitt's assumption of “rationality”, which seems to be more or less the equivalent of seeing the worst in everybody.

It's rather trivial to arrive at a different reading of the data. The wrestler with the poorer record has a greater motivation to do his absolute best, while the wrestler with the worse has less. That requires no conspiratorial collusion, the existence of which is yet another assumption Levitt takes in forming his hypothesis. And there are certainly other possible explanations of the data that are equally legitimate and have not made themselves obvious. Yet, for the sake of intellectual honesty, Levitt may yet be right: maybe the wrestlers really are involved in some huge conspiracy. However, there is no empirical way for us to confirm that, and we should therefore be obliged to viewing his claims with skepticism.

Another topic that frequently is connected with rationality is the Efficient Market Hypothesis, best known through Burton Malkiel's “A Random Walk Down Wall Street.” The hypothesis states that the market (for stocks, bonds, and any other investment vehicles) will set prices such that they represent the best possible estimate of its value. With stocks, for example, the price will represent its present and future dividends. As such, individual investors should not pick and choose particular stock, since they cannot outsmart the market, and should instead invest in index funds so as to spread their risk. Over time, however, especially in recent years, this theory has met widespread skepticism due to massive shocks that cannot possibly represent changes in the underlying value of the investments, as exemplified by the recent crash. This criticism is likely warranted. What is not warranted is using the collective irrationality of financial markets as blunt object with which to bludgeon the concept of individual rationality.

Referring to this as “irrationality” confuses the issue altogether. To paraphrase James Surowiecki, what is desired is for markets to be “accurate”, which connotes something altogether different than “rational”. If we want to know if individuals were acting rationally, we need to be asking questions of another kind. Were they trying to achieve a goal? Were they using the information at their disposal to guide those decisions? I believe the answer to both those questions must be yes. After the fact, perhaps it's clear that they were using incorrect information, but they did not know that. Even someone who was aware of what was really going on was in all likelihood just trying to time exiting the market. Economically, the investors were still rational, even if taking on the features of “irrational exuberance” when taken as a group.

Academics should and do take the crash as evidence against Efficient Market Hypothesis, perhaps not enough. That's fine. But to use it as an excuse for further government intervention is a non sequitur, especially outside of financial markets. A big target for this blunt object has been the teachings of the Chicago School, especially the political and monetary prescriptions of Milton Friedman, which is absurd, as his central contributions had little to do with finance outside of the Fed. And this is precisely because he argued with the correct definition of rationality. His opponents have equated market “irrationality” with Friedman's beliefs in order to Straw Man him out of existence.

See the very recent “The Myth of the Rational Market” as an example of this, as well as many articles by Paul Krugman. See the entire oeuvre of Robert Shiller for a more theoretical justification discussion of the irrationality of markets.

Rationality doesn't, or shouldn't, have anything to do with an individual's ability to make mistakes. Or to fail to act selfishly. Or to act in such a way that does not achieve full employment. If we allow rationality to mean more than what was initially posited, we may accidentally come across a situation where the stock market prices a company perfectly or that some jerk was acting “rationally” to screw his neighbors to make a buck, but such instances do not represent (and in reality, shouldn't have ever had to represent) rationality. We are all rational by acting as we do. Our mistakes and vices contrary to that are our errors. They are not irrationality.