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Economics

Greenspan and understanding rationality

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Alan Greenspan was the chairman of the Federal Reserve, one of the most powerful monetary institutions of the world, for 18 years. He was heralded for an era so prosperous, that the US actually turned off their debt clock in 2000. Unfortunately, post-facto, he was also perhaps guilty of setting the policies that created the Great Recession.

When Congressman Waxman inquired, “Were you wrong?” Greenspan responded, “Partially … I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms … I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. I had been going for 40 years with considerable evidence that it was working exceptionally well. ”

Essentially, he assumed that people would be rational.

Unfortunately, there is a vast amount of data showing that human beings are irrational and fickle. Economic rationality is at a premium. For instance, it’s most beneficial to buy a used car after 2-3 years, hold it for 7-10 years, and then sell it after the maintenance costs become too high. It’s generally well known that cars depreciate the most in the first two years, so why would anyone rational possibly want to do that?

But the issue of rationality is really about understanding the conflicting desires of the human condition. Is the smell of a brand new car worth it? Does it feel nice to have something that’s brand new? Or on the opposite side of the spectrum with poverty, are people poor because they are irrational? Why would anyone pay 20% interest for an upfront cost to cash a check two days in advance? It may seem economically irrational, but these decisions seem much more rational when you’re hungry.[i]

Strict economic rationality for wealth maximization just doesn’t encompass the human condition. It neglects the almost arbitrary assignment of likes, the complexity of the culture, and how we construct the models of our world. Greenspan had a model, a framework if you will, that was working well for 40 years. What happened? If the banks were rational, why was the Glass-Steagall Act of 1933 to separate investment and commercial banking activities necessary in the first place? Why is this type of regulation not necessary in other countries? How could he make the mistake of assuming rationality?

The answer comes down to the culture of the society and the construction of the model. Greenspan had a model of the world consisting of rational self-interest. A strict mathematical definition of rationality from game theory involve four axioms from von Neumann and Morgenstern (1947) involving comparability, consistency, ranking, and independence. Essentially, they are saying that given a set of choices, people can rank them consistently based on their preferences and values. Economically speaking, a rational economic actor is one who desires wealth and to minimize work or perhaps more general than that as choosing the appropriate means for a desired end.[ii]

However, there are many cases of economic irrationality and non-economic rationality. For instance, in India, there is an organization called Operational Asha that treats tuberculosis. They found that people would walk 2 km further than their nearest clinic for treatment. Why? Because culturally those with tuberculosis would be rejected from the family if they found out. Economically irrational, but it certainly makes perfect sense with the entire picture. Or why is there no culture of saving in poor regions? Due to unforeseen events such as funerals or medical expenses, people actually have to borrow and raise money. In other words, they are giving up money for social equity, which is a different way of saving I suppose.

I could construct a similar story for the employees of banks. Perhaps the choices were between the massive bonuses to meet short-term profit margins or to think 5-years into the future about the effect of sub-prime mortgages and receiving a reduced paycheck. What if the prevailing model of the day was that housing always goes up? What if a prevailing economist stated, “Although a ‘bubble’ in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.”[iii] Why would someone not believe Greenspan, an economic rockstar, even though he may have been trying to keep confidence in the markets? Who would accept any other models?

And, in the end, you can’t make someone understand something he’s being paid not to. The individuals at the banking organizations were certainly being rational selling subprime mortgages. And the individuals that set the policies at the banks stood to make a great deal of money on the short-term numbers. Some members of Bear Stearns knowingly sold risky subprime mortgages and in a lawsuit against them emails were released which indicate the same. One email stated, “I refuse to receive any more emails from [a Bear Stearns Senior Managing Director] (or anyone else) questioning why we’re not funding more loans each day…I’ll do whatever is necessary to make sure you’re successful in meeting this objective.[iv] A mandate for aggressive growth and golden parachutes for potential failure does have a tendency to cause a neglect for the long-term, which depending on your point of view, may or may not be economically rational.

Back to Greenspan. Did he believe that banks would act in their interest of self-preservation? Sure. He had a functioning and working model and was right for so long, he did not have enough data to change his mind. I’ve already commented on the model of a completely free market and the invisible hand.

But what’s really interesting isn’t Greenspan’s model, but his neglect of the culture in evaluating the effects of his model that actors are rational and markets are self-correcting. The experiment was already done in the United States with the Great Depression and Glass-Steagall being enacted was the result. In different cultures, where the desire for wealth, growth, and search for profit is more moderate, the model is more stable and Glass-Steagall isn’t necessary. For instance, in Canada, the banks are remarkably stable for now, and there is no equivalent separation of commercial and investment banks. Both the banks and the borrowers are more conservative in Canada compared to the US. Not only do models have to be evaluated on their own merit, but also with respect to the people and environment in which they will be functioning.

tl;dr – Economic rationality needs to include cultural and behavioural biases. And you can’t ask an expert if he’s wrong until after the fact.

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  1. http://www.princeton.edu/chw/events_archive/repository/Spears120110/Spears120110.pdf []
  2. There is also an interesting treatment by Dan Ariely in Predictably Irrational which focuses on inherent biases – aka fearing losing more than desiring gain. []
  3. It was Greenspan in 2005 []
  4. http://www.huffingtonpost.com/2012/10/01/bear-stearns-mortgage-bond-emails_n_1930731.html []
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