The Idea of Perfectly Rational People is Crazy

by Will on September 2, 2010

Economists and libertarians like to pretend that people are perfectly rational. That’s because if it were true, economists would be very important and libertarian policy would work well. Even when something looks really irrational, their instinct is to find a way to consider it rational.

This annoyed me recently when I posted a link to the wikipedia page about “Tulip Mania.” This was a speculative bubble in 1600s Holland where tulips became very valuable, and people spent lots of money on them just as an easy investments. Obviously this ended in a huge bust where lots of people lost a lot. The article’s intro notes: “some modern economists have proposed rational explanations, rather than a speculative mania, for the rise and fall in prices.” Think about how crazy that is. We are discussing people spending their life’s savings on a tulip, thinking they’ll reap windfall profits. And “some modern economists” want to say, no, they were perfectly rational after all. Weird.

In Brad DeLong’s recent lecture on Depression Economics he mentioned, along with the Keynesian and Friedmanite schools, a third way of thinking about the business cycle: the Minskyite school. When I was in school, they didn’t tell me anything about Minsky. His wikipedia page says:

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. ..

This slow movement of the financial system from stability to crisis is something for which Minsky is best known, and the phrase “Minsky moment” refers to this aspect of Minsky’s academic work…

“A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”[7]

Disagreeing with many mainstream economists of the day, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a so-called free market economy – unless government steps in to control them, through regulationcentral bank action and other tools. Such mechanisms did in fact come into existence in response to crises such as the Panic of 1907 and the Great Depression. Minsky opposed the deregulation that characterized the 1980s.

This sounds right to me. Financial markets are susceptible to people’s euphoric hope that they can get something for nothing, and their wish for that to be true clouds their perception of the real risks involved. Furthermore, this is not particular to the financial sector: people do things contrary to their self-interest all the time. They seek the euphoric thrill of a drug experience, even though it could kill them or ruin their health. They seek the euphoric thrill of an affair, even though it may ruin the home life on which they rely. They drive really fast in large boxes of metal, even though that could get them a ticket or lead to their death. They’re not perfectly rational! They are somewhat rational, but that’s not the end of the story. It’s fairly crazy that Hyman Minsky had to “disagree with many mainstream economists of the day” to point this out.

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