Sunday, July 20, 2014

Rationality is beside the point

Brad DeLong has a post wherein he poses the question
Given that people aren't rational Bayesian expected utility-theory decision makers, what do economists think that they are doing modeling markets as if they are populated by agents who are?
intimating that maybe some ideal modeling scheme exists where you just need to replace the "rational Bayesian" with "behavioral". Along with most economists out there with objections to rational expectations, it seems most econoblog commenters are objecting to the "rational", rather than e.g. me who objects to the "expectations".

DeLong then quotes Andrew Gelman on how nonlinear utility functions used in economics are suspect and how students believe each step of a utility argument, but are "unhappy with the conclusion". The students seem confused by their own reasoning. Noah Smith has a post from earlier this year on other problems with utility functions. Cosma Shalizi sums it up pretty well (emphasis mine):

The foundation on which the neo-classical framework is raised, though, is an idea about rational agents: rationality means maximizing expected utility, where expectations come from maintaining a coherent subjective probability distribution, updated through Bayes's rule; moreover, the utility function is strictly self-regarding. This is a very well-specified idea, readily formalized in clean and elegant mathematics. Moreover, there's pretty much only one way to formalize it, which makes the mathematical modeler's life much easier. All of this appeals to certain temperaments, mine very much included. Alas, experimental psychology, and still more experimental economics, amply demonstrate that empirically it's just wrong.
All true.

Yet markets seem to work.

This is actually pretty remarkable. We're totally irrational potentially hyperbolic discounters subject to framing effects ... yet markets seem to work.

But! This is only pretty remarkable if you see markets as some kind of system that efficiently allocates resources. If we look at my recent post where I attempt a definition of aggregate demand using the information transfer model, then we see the efficient allocation of resources is not the proper frame. A market transfers any information, not necessarily useful, rational or efficient information. Transferring completely crazy information accurately is considered more of a success in this framework than transferring a correct prediction about the future only nine times out ten.

"Gold is going to a million dollars an ounce."

"Inflation will take off at any minute."

The market is "inefficient" when these statements are inaccurately transferred from the aggregate demand to the aggregate supply, not when they are wrong. Of course, for the information to be transferred accurately some element of the aggregate supply has to receive the information accurately. And the world might work in such a way that really crazy information is almost never received accurately -- the person on the other end of a gold transaction really just wants to make a not unreasonable amount of money and thinks gold is going to fall in value [1]. Maybe our normal cognitive biases are transferred accurately, yet markets work [2]. I don't know all the answers. 

I do know that assuming the information is transferred fairly accurately gives you supply and demand diagrams. It also does a good job predicting inflation. So maybe we shouldn't worry too much about rationality or individual utility functions.

At least, if you use the information transfer model.

[1] It is interesting that people who are selling gold seem in advertisements seem to put forward the attitude that one should have when one wants to buy gold ... it's a safe asset, you'll stay rich or become richer if you buy gold; shouldn't these sellers just hold on to their gold? This is the opposite of many other advertisements which usually say something like we have a lot of TVs and we can't possibly watch them all so we implore you to come on down to Crazy Eddie's and take them off our hands.

[2] I'd like to make the distinction between where an unfettered market leads to a Pareto efficient allocation and where an unfettered market leads to some sub-optimal allocation. In both cases, the information transfer may be "efficient" in the sense that the information received is the information transmitted. It may not be socially optimal.

9 comments:

  1. Jason, do you think there are any economists out there that are likely to agree with this, or is this position uniquely your own? My sense is that you are unique in this view.

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    1. It is a bit iconoclastic :)

      I imagine the view would probably be mocked. I was in the process of composing an update/postscript to this post. Is the idea of utility in economics a byproduct of our own human sense of agency rather than any solid reasoning?

      Were we led astray because we as humans were too close to the problem? Noah Smith mentions something that touches on this in one of his microfoundations posts -- he said we don't know if gravity has microfoundations, but we do know that economics does (it's people).

      Did we just assume that humans (agents, firms, households) are the microfoundations? Maybe the microfoundations should be based on information ...

      And since we're at the "micro" level and we know we have thoughts, did we go ahead an allow them into economics because, hey, they must matter? That's really not a good reason.

      In one of my first posts, I mention that my approach is that of an alien observer who has good enough instruments to see how nighttime lights are increasing and CO2 is increasing on Earth, land is cleared and posits the idea of a "civilization" on Earth that operates under a theory of "economics" ... analogous to Boltzmann positing atoms operating under a theory of statistical mechanics.

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    2. I look forward to your next post. Thanks.

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    3. Cheers, Tom.

      I'm not sure the idea I mentioned is going to come out "next" ... I really need to go back and read Adam Smith. I'm not sure who first used "expectations" either ... you'd think there would be a wikipedia on "expectations" in economics, but it sends you to "rational expectations" and there's another page on "adaptive expectations".

      This all makes sense from the standpoint of my thesis: why discuss something so (apparently) patently obvious?

      The next post is likely one that suggests the nutty idea that maybe you should only ever use fiscal policy for macro stabilization ... ha!

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    4. This comment has been removed by the author.

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    5. I drafted a response without seeing that you had deleted the comment :)

      I can still post it if you're interested.

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    6. Sure!... I just thought my comment was too long... I meant to get back to it and make it more brief. But sure, I'd like to see your response.

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    7. (Response to deleted comment.)

      Thanks for the compliment, Tom.

      I will say that the hard sciences rarely follows the "state hypothesis, conduct experiment, and test it" paradigm itself. (Ironically, I see it more in the softer sciences, especially sociology.) In physics, division of labor has set in and those pieces are done by theorists, experimentalists and phenomenologists, respectively. I was more of a phenomenologist, so I probably harp on the data more than most physicists would. Eric Weinstein would be more of a theorist. In this view, most macroeconomists are "theorists" (Krugman, Sumner). Econometricians and Fed economists are "phenomenolgists". The Fed, BEA and BLS are the "experimentalists" collecting the data (or in the case of the Fed, moving the levers).

      I don't think it is necessary that the one who proposes an idea be the same person who either figures out how to test it or what would invalidate it (these are related). Sometimes the "experimentalists" are better at figuring it out. My friend's group while I was in grad school came up with an idea of how to test for the existence of "large" extra dimensions in string theories (the length scales of extra dimensions must be smaller than ~ 1mm).

      That is to say with the division of labor, it isn't the job of a given "scientist" to consider the data or even give up on his or her hypothesis. Planck had a great quote about how no one changes their mind, they just die off and future students either accept those theories or reject them. Sumner is under no obligation to change his mind; the onus is on those that agree to make sure future students are persuaded and on those that disagree to convince future students reject his ideas.

      That said, the hot potato effect seems to be supply and demand with sticky prices (both reasonably established) and expectations. Krugman says that there is no way for expectations of higher inflation to happen in a liquidity trap (that sort of defines liquidity trap). Sumner says that the Fed isn't guiding those expectations. Hey, even I believe "expectations" can move markets (or cause events to fail to move markets) in the short run ... but the results may be indeterminate from a modeling standpoint.

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    8. Thanks Jason. That's helpful. You write:

      "Sumner says that the Fed isn't guiding those expectations."
      Is the following longer statement consistent with your intended meaning here:

      "Sumner says that the Fed has failed to guide those expectations, but is capable of doing so."

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