The question of whether market participants are rational can get tricky. I think Jon Elster is right that there's a peculiar form of irrationality that he calls "hyper-rationality." This involves taking Baylesian probability theory to its absurd conclusions. For a Baylesian, decision-making under conditions of incomplete information are no different from decisions under conditions of complete information, no matter how incomplete your information. You simply ignore what you don't know and make a decision based on what you do know. One of Elster's favorite examples is child custody cases. Decisions in these cases matter a lot, but judges infrequently know what they need to know to make good decisions. So, judges end up making decisions (because they have to) based on information that is readily available, but almost inconsequential. (In one of Elster's cases, if I recall correctly, the father got custody because he was one block closer to the child's school). From a Baylesian perspective, that's rational. For most people, I'd guess, not so much.
I remember once trying to make a really rational decision in financial markets. In the late 90s I was trying to figure out how to allocate my TIAA-CREF money. Being an avid reader of LBO, I knew that this bubble was going to burst sometime, so I spent a lot of time worrying about whether I should move all of my retirement money out of stocks. So, I had to make a decision on financial risk based on quite a bit of information. I knew that stocks were overpriced. I knew that the tech boom was really out of hand. But I decided to stay in a fund that was about 55% in stocks at the time. Why? (1) I was a good 25 years from retirement, and so short or even medium-term stock prices weren't a big concern for me. In fact, a price correction fairly early in my career had its good points. It meant that I was buying low. (2) If I did get out of stocks and wanted to end up ahead, I'd also have to know when to get back into stocks. I decided I wasn't that smart. Now, if I'd been 5 years away from retirement, I would have gotten out of stocks and breathed a sigh of relief. If agents were rational, I think markets would be pretty good at pricing in this kind of risk.
On the other hand, what if I were a trading in oil futures, or some complex oil futures derivative that I might have understood right after I read _Wall Street_, but don't now? Then I'd be forced to trade based on my guess about what the price of oil will be in a year. That's a decision much more like the judge trying to award custody. The information that matters is impossible to know, and the information that's at hand has only limited value. Prices based on decisions made under that kind of uncertainty, rather than under conditions of calculable risk, can get apeshit crazy. Today's headlines may have almost nothing to do with the price of oil in a year, but they're the only information you have, so prices swing like nuts.
(Now, probably, from a technical economic point of view risk and uncertainty aren't dichotomous like this. You'd have to think of a continuum where risk represents decision-making with a small confidence interval and uncertainty represents decision-making with a large confidence interval, and lots of decisions fall somewhere in the middle).
So, the conclusion is - markets in uncertainty, even though they can be modeled like risk markets, act very differently. But markets have to generate prices in cases of uncertainty, just like in cases of risk. It's those cases where markets are "inefficient".
And yes, all of that with "rational" or "hyperrational" agents. I'm not so sure about mob psychology. You could argue that "mob psychology" merely means that people make "rational" decisions based solely on the most readily available information, the current trend of prices. This is the kind of "rationality" that you see touted in books like _Blink_. It's also the kind of "rationality" that Samuel Popkin lauded in his book, _The Rational Voter_, about 15 years ago. (This was an attack on the school, going back to Philip Converse, that points out how ill-informed voters are. Popkin argues that voters are very rational. They're so rational that they forego the costs of information-gathering.)
Instead of calling it mob psychology, why not just come out and say that most people are dumbasses? "Dumbass" would be a technical term meaning that: (1) Most people don't know very much. (2) Most people "know" things that aren't true. (3) Most people can't evaluate which things they "know" are likely to be true and which are not. (4) Most people can't tell which things they know are important and which aren't for a particular decision. (5) Most people, even when they have all the pieces of information they need right in front of them to make a rational decision, can't reason their way through to a valid conclusion.
Model that!
Michael McIntyre
On Sep 20, 2006, at 10:04 AM, Doug Henwood wrote:
>
> On Sep 20, 2006, at 9:14 AM, Michael McIntyre wrote:
>
>> I wouldn't call a market where prices go apeshit crazy (my words)
>> an efficient market, so my intent was never to give an opening to
>> capitalist apologetics. When it comes to markets and information,
>> I guess I'm much more in line with Stiglitz, Akerloff, etc. who
>> emphasize how information asymmetries lead to inefficient
>> markets. For example, I think it was Akerloff who wrote the early
>> paper "The Market in Lemons" about used car prices.
>
> Yup it was Akerlof.
>
> But what exactly do you mean by efficiency? In financial theory, an
> efficient market is simply one that reflects all available
> information, which is pretty much true of all deep, liquid
> financial markets. The quality of that information is another
> matter entirely.
>
> Stiglitz & Akerlof want to assume that market participants are
> rational, even though they may be differently informed. The first
> time I met Stiglitz, late in the dot.com boom, he asked "Why do
> people buy those stocks?" That's a different POV from, say, Robert
> Shiller (or master speculators like George Soros) who believe that
> markets are venues for mob psychology, which means you can have
> lots of periods of apeshit craziness that can go on for a long
> time. As the old saying has it - which was quoted somewhere
> yesterday on the Amaranth disaster - markets can stay irrational a
> lot longer than you can stay solvent. Markets that efficiently
> reflect apeshit craziness can be efficient in the financial sense,
> if not in the colloquial or engineering sense.
>
> Doug
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