THE BLOG
10/21/2013 09:51 am ET Updated Jan 23, 2014

Random thoughts on rational decline

This has been a rough few weeks for Rational Man. In fact, this has been a difficult decade or more for the concept, central to both the Enlightenment and to what used to be called (in more modest times) the American experiment: the blue-plate combo of free-market economics and representative democracy. Just this week, those avatars of scientific progress and enlightened thought - that would be the Nobel committee - managed to bestow this year's economics prize upon three very different economists. The conceptual lassoing of these three showed more ingenuity than usual: Eugene Fama, Robert Shiller and Lars Peter Hansen, shared the Big Prize for casting light upon what the committee called "asset pricing," that is, how markets function. Did it matter that the light they cast upon these matters came from different sources and produced different answers? Did it matter that Fama and Shiller, in particular, took divergent views of what both consider fundamental issues: namely, the degree to which markets are efficient, and, thus, rational. Not presumably to the Nobel committee, which seemed eager to embrace a kind of Miltonic belief that from discord emerges wisdom and that disagreement produces a higher level of generalization.

Fama famously articulated the notion that financial markets were efficient, that is capable of rapidly processing all available information. This helped explain important phenomena, like the fact that few investors can beat the market over time. It assumed that "the market" - or rather a collectivity of investors - is not only alert but rational; it naturally gravitates to the right answers It helped spawn the belief that markets were the best predictors of the future that we have. And when markets got bubbly and crashed, the legion of efficient market advocates took refuge in that most ironic of gambits for a quantitative gang: rhetorical hair-splitting. They began fooling with definitions, subdividing efficiency by strength like chili, or playing the long-term versus short-term game, or, as Fama once said, denying that the word "bubble" had meaning. Shiller, on the other hand, established a reputation for predicting bubbles, both the dot com and real estate varieties. He did not believe in efficiency or that investors were rational; he viewed them as beset by behavioral tendencies that often bordered on irrationality - he wrote, after all, "Irrational Exuberance" and, with George Akerlof, "Animal Spirits." Shiller disagreed with Fama and said so. But while Fama struggles to explain how bubbles can occur in efficient markets, Shiller's behaviorism has less to say about beneficent, long-running markets, that is, the long and lucrative run-up to bubbledom. As Fama once said, Shiller was forecasting bubbles in 1996.

And then there's Congress, specifically the Tea Party. It's hard not to see that the antics of House Republicans over the past few weeks as a kind of bubble phenomena, at least metaphorically. (A warning: metaphorical bubbles are tossed around promiscuously.) Tea Party leaders argued that they were representing the will of the public; that they were winning; that the realities they perceived - about Obamacare, global financial markets, the economy, the Democrats including the foreign-born, Muslim president - were, well, real. Obamacare was a cancer; default was no big deal; the Democrats would cave; the public was behind them; nearly everything occurring was unconstitutional. Were they rational in any of these beliefs? Were they accurate in any of their predictions? Were they even effectively absorbing, in an efficient market sense, available information? Again, like the more fervent advocates of efficient markets, the appearance of a setback to their view of the world involves some rhetorical sleight of hand, notably the argument that in the long run they'd be proven right, a recourse to that old Marxist theme and threat that history was on their side, justifying nearly any means to history's end. (Need it be said that Keynes famously blew up that logic with his line that "In the long run, we're all dead?")

So what's rational? The fact is most market players believe they are acting rationally; so do most people. It's everyone else that's the problem. We look at each other regularly and say: I'm as rational as Spinoza, but you, my friend, are shrouded in fog, nutty as a fruitcake, unthinking, moronic, unhinged, prone to sentiment and bias. We predict the future by looking back. The raw material for rationality is the accumulated data of the past. Acting rationally toward the future thus hangs on our uncertain, subjective and often crude ability to interpret history. You see this with Tea Partiers, who claim special insight into the founding of the Republic, and the nature of Constitutional intent; you see it even with higher-flown thinkers like Antonin Scalia with his Constitutional originalism, a jurisprudential methodology Richard Posner dismantles in his recent "Reflections on Judging." Those who put faith in markets believe in a single shining equilibrium, somewhere beneath the random walk of prices, which markets drift towards like a boat on the tide. Personally, this seems to me Panglossian. While history may seem to some to be baffling and subjective, to others it is simple, clear and objective (nothing has greater clarity than historical paranoia). Some of us may believe individuals have different interests, needs, personalities and goals. But others, including certain schools of economists, see human diversity as a cover for one-dimensional drives, economic self-interest, say, or biblical faith.

Let's be optimistic: We are not crazy. But we can't see very far into the future. And the past is pretty murky too. We like to believe we are rational, but our actions belie that; for what is rational at the time may appear wrong, nutty, even criminal depending on the version of the future that befalls us. We may not be omniscient but we are, as a species, empirical. We live in a present - an eternal present -- that teaches us lessons daily. We hypothesize and experiment; that's one of both the markets' and democracy's greatest virtues: They are both petri dishes of continual experimentation. (A Harvard economist - John Bates Clark and MacArthur winner Raj Chetty -- in Monday's New York Times argues that economics is becoming more empirical, more scientific, through new ways of experimentation and the use of big data. He doesn't deal with the difficulties of humanity as predictive subjects, or the dependence on the past as a funhouse mirror for the future. He also doesn't mention how many generations of economists made much the same claim.) This explains both the random walk of markets and the sense that we stumble forward politically like drunken sailors. In the great scheme of things, perhaps only God, or some cosmic computer, can predict the future by understanding the past: good-by free will, hello predestination. Not knowing if a God-like big-data calculator exists, however, the commonsensical approach for the rest of us may be certain modesty toward sweeping statements and skepticism of utter certitude. The heights of rationality, in this sense, may involve understanding our limits and accepting our imperfections.

All that's not to say that we can believe every damn thing we want, and justify that belief as a reason to act. Empiricism still operates. Over time, it has established "facts" from fancy; entire fields have been taken out of the realm of the speculative and turned into pretty-well-known-if-possibly-unprovable - even in economics and politics. It is a flickering candle in a dark world, but it works. We could use a flashlight or two.