resilience, not stability

Agent Irrationality and Macroeconomics

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In a recent post, Rajiv Sethi questions the tendency to find behavioural explanations for financial crises and argues for an ecological approach instead – a sentiment that I agree with and have touched upon in previous posts on this blog. This post expands upon some of these themes.

A More Realistic View of Rationality and Human Cognition, Not Irrationality

Much of the debate on rationality in economics focuses on whether we as human beings are rational in the “homo economicus” sense. The “heuristics and biases” program pioneered by Daniel Kahneman and Amos Tversky argues that we are not “rational” – however, it does not question whether the definition of rationality implicit in “rational choice theory” is valid or not. Many researchers in the neural and cognitive sciences now believe that the conventional definition of rationality needs to be radically overhauled.

Most heuristics/biases are not a sign of irrationality but an entirely rational form of decision-making when faced with uncertainty. In an earlier post, I explained how Ronald Heiner’s framework can explain our neglect of tail events as a logical response to an uncertain environment, but the best exposition of this viewpoint can be seen in Gerd Gigerenzer’s work which itself is inspired by Herbert Simon’s ideas on “bounded rationality”. In his aptly named book “Rationality for Mortals: How People Cope with Uncertainty”, Gigerenzer explains the two key building blocks of “the science of heuristics”:

  • The Adaptive Toolbox: “the building blocks for fast and frugal heuristics that work in real-world environments of natural complexity, where an optimal strategy is often unknown or computationally intractable”
  • Ecological Rationality: “the environmental structures in which a given heuristic is successful” and the “coevolution between heuristics and environments”

The irony of course is that many classical economists had a more accurate definition of rationality than the one implicit in “rational choice theory” (See Brian Loasby’s book which I discussed here). Much of the work done in the neural sciences confirms the more nuanced view of human cognition espoused in Hayek’s “The Sensory Order” or Ken Boulding’s “The Image” (See Joaquin Fuster on Hayek or the similarities between Ken Boulding’s views and V.S. Ramachandran’s work discussed here).

Macro-Rationality is consistent with Micro-Irrationality

Even a more realistic definition of rationality doesn’t preclude individual irrationality. However, as Michael Mauboussin pointed out: “markets can still be rational when investors are individually irrational. Sufficient investor diversity is the essential feature in efficient price formation. Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices. Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency. So the issue is not whether individuals are irrational (they are) but whether they are irrational in the same way at the same time. So while understanding individual behavioral pitfalls may improve your own decision making, appreciation of the dynamics of the collective is key to outperforming the market.”

Economies as Complex Adaptive Systems: Behavioural Heterogeneity, Selection Pressures and Emphasis on System Dynamics

In my view, the ecological approach to macroeconomics is essentially a systems approach with the emphasis on the “adaptive” nature of the system i.e. incentives matter and the actors in a system tend to find ways to work around imposed rules that try to fight the impact of misaligned incentives. David Merkel explained it well when he noted: “People hate having their freedom restrained, and so when arbitrary rules are imposed, even smart rules, they look for means of escape.” And many of the posts on this blog have focused on how rules can be subverted even when economic agents don’t actively intend to do so.

The ecological approach emphasises the diversity of behavioural preferences and the role of incentives/institutions/rules in “selecting” from this pool of possible agent behaviours or causing agent behaviour to adapt in reaction to these incentives. When a behaviourally homogeneous pool of agents is observed, the ecological approach focuses on the selection pressures and incentives that could have caused this loss of diversity rather than attempting to lay the blame on some immutable behavioural trait. Again, as Rajiv Sethi puts it here: “human behavior differs substantially across career paths because of selection both into and within occupations….[Regularities] identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.”

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Written by Ashwin Parameswaran

June 24th, 2010 at 8:50 am

2 Responses to 'Agent Irrationality and Macroeconomics'

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  1. [...] on financial instability, and similar themes have been explored elsewhere; see especially Macroeconomic Resilience and David Murphy. As I said in an earlier post, a bit too much is being asked of behavioral [...]

  2. [...] above would seem to be a distinctly unscientific and “irrational” method. But as I have argued before, heuristics and intuition are rational responses in an uncertain environment where time and [...]

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