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Monday, July 30, 2007

Tyler Cowen and rationality

I recently came across the paper How economists think about rationality by Tyler Cowen. Highly recommended -- a clear and honest overview.

The excerpt below deals with rationality in finance theory and strong and weak versions of efficient markets. I believe the weak version; the strong version is nonsense. (See, e.g, here for a discussion of limits to arbitrage that permit long lasting financial bubbles. In other words, capital markets are demonstrably far from perfect, as defined below by Cowen.)

Although you might think the strong version of EMH is only important to traders and finance specialists, it is also very much related to the idea that markets are good optimizers of resource allocation for society. Do markets accurately reflect the "fundamental value of corporations"? See related discussion here.

Financial economics has one of the most extreme methods in economic theory, and increasingly one of the most prestigious. Finance concerns the pricing of market securities, the determinants of market returns, the operating of trading systems, the valuation of corporations, and the financial policies of corporations, among other topics. Specialists in finance can command very high salaries in the private sector and have helped design many financial markets and instruments. To many economists, this ability to "meet a market test" suggests that financial economists are doing something right. Depending on one's interpretation, the theory of finance makes either minimal or extreme assumptions about rationality. Let us consider the efficient markets hypothesis (EMH), which holds the status of a central core for finance, though without commanding universal assent. Like most economic claims, EMH comes in many forms, some weaker, others stronger. The weaker versions typically claim that deliberate stock picking does not on average outperform selecting stocks randomly, such as by throwing darts at the financial page. The market already incorporates information about the value of companies into the stock prices, and no one individual can beat this information, other than by random luck, or perhaps by outright insider trading.

Note that the weak version of EMH requires few assumptions about rationality. Many market participants may be grossly irrational or systematically biased in a variety of ways. It must be the case, however, that their irrationalities are unpredictable to the remaining rational investors. If the irrationalities were predictable, rational investors could make systematic extra-normal profits with some trading rule. The data, however, suggest that it is very hard for rational investors to outperform the market averages. This suggests that extant irrationalities are either very small, or very hard to predict, two very different conclusions. The commitment that one of these conclusions must be true does not involve much of a substantive position on the rationality front.

The stronger forms of EMH claim that market prices accurately reflect the fundamental values of corporations and thus cannot be improved upon. This does involve a differing and arguably stronger commitment to a notion of rationality.

Strong EMH still allows that most individuals may be irrational, regardless of how we define that concept. These individuals could literally be behaving on a random basis, or perhaps even deliberately counter to standard rationality assumptions. It is assumed, however, that at least one individual does have rational information about how much stocks are worth. Furthermore, and most importantly, it is assumed that capital markets are perfect or nearly perfect. With perfect capital markets, the one rational individual will overwhelm the influence of the irrational on stock prices. If the stock ought to be worth $30 a share, but irrational "noise traders" push it down to $20 a share, the person who knows better will keep on buying shares until the price has risen to $30. With perfect capital markets, there is no limit to this arbitrage process. Even if the person who knows better has limited wealth, he or she can borrow against the value of the shares and continue to buy, making money in the process and pushing the share price to its proper value.

So the assumptions about rationality in strong EMH are tricky. Only one person need be rational, but through perfect capital markets, this one person will have decisive weight on market prices. As noted above, this can be taken as either an extreme or modest assumption. While no one believes that capital markets are literally perfect, they may be "perfect enough" to allow the rational investors to prevail.

"Behavioral finance" is currently a fad in financial theory, and in the eyes of many it may become the new mainstream. Behavioral finance typically weakens rationality assumptions, usually with a view towards explaining "market anomalies." Almost always these models assume imperfect capital markets, to prevent a small number of rational investors from dwarfing the influence of behavioral factors. Robert J. Shiller claims that investors overreact to very small pieces of information, causing virtually irrelevant news to have a large impact on market prices. Other economists argue that some fund managers "churn" their portfolios, and trade for no good reason, simply to give their employers the impression that they are working hard. It appears that during the Internet stock boom, simply having the suffix "dot com" in the firm's name added value on share markets, and that after the bust it subtracted value.11

Behavioral models use looser notions of rationality than does EMH. Rarely do behavioral models postulate outright irrationality, rather the term "quasi-rationality" is popular in the literature. Most frequently, a behavioral model introduces only a single deviation from classical rationality postulates. The assumption of imperfect capital markets then creates the possibility that this quasi-rationality will have a real impact on market phenomena.

The debates between the behavioral theories and EMH now form the central dispute in modern financial theory. In essence, one vision of rationality -- the rational overwhelm the influence of the irrational through perfect capital markets -- is pitted against another vision -- imperfect capital markets give real influence to quasi-rationality. These differing approaches to rationality, combined with assumptions about capital markets, are considered to be eminently testable.

Game theory and the failed quest for a unique basis for rationality:

Game theory has shown economists that the concept of rationality is more problematic than they had previously believed. What is rational depends not only on the objective features of the problem but also depends on what actors believe. This short discussion has only scratched the surface of how beliefs may imply very complex solutions, or multiple solutions. Sometimes the relevant beliefs, for instance, are beliefs about the out-of-equilibrium behavior of other agents. These beliefs are very hard to model, or it is very hard to find agreement among theorists as to how they should be modeled.

In sum, game theorists spend much of their time trying to figure out what rationality means. They are virtually unique amongst economists in this regard. Game theory from twenty years ago pitted various concepts of rationality against each other in purely theoretical terms. Empirical results had some feedback into this process, such as when economists reject Nash equilibrium for some of its counterintuitive predictions, but it remains striking how much of the early literature does not refer to any empirical tests. This enterprise has now become much more empirical, and more closely tied to both computational science and experimental economics.

Computational economics and the failed quest for a unique basis for rationality:

Nonetheless it is easy to see how the emphasis on computability puts rationality assumptions back on center stage, and further breaks down the idea of a monolithic approach to rationality. The choice of computational algorithm is not given a priori, but is continually up for grabs. Furthermore the choice of algorithm will go a long way to determining the results of the model. Given that the algorithm suddenly is rationality, computational economics forces economists to debate which assumptions about procedural rationality are reasonable or useful ones.

The mainstream criticism of computational models, of course, falls right out of these issues. Critics believe that computational models can generate just about "any" result, depending on the assumptions about what is computable. This would move economics away from being a unified science. Furthermore it is not clear how we should evaluate the reasonableness of one set of assumptions about computability as opposed to another set. We might consider whether the assumptions yield plausible results, but if we already know what a plausible result consists of, it is not clear why we need computational theories of rationality.

As you can tell from my comments, I do not believe there is any unique basis for "rationality" in economics. Humans are flawed information processing units produced by the random vagaries of evolution. Not only are we different from each other, but these differences arise both from genes and the individual paths taken through life. Can a complex system comprised of such creatures be modeled through simple equations describing a few coarse grained variables? In some rare cases, perhaps yes, but in most cases, I would guess no. Finance theory already adopts this perspective in insisting on a stochastic (random) component in any model of security prices. Over sufficiently long timescales even the properties of the random component are not constant! (Hence, stochastic volatility, etc.)

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