Thursday, September 24, 2009

Frydman and Goldberg on "Rationality"

A very important piece on the impossible standards of economic rationality that lead, in reaction, to claims of "irrationality"; coauthored by Roman Frydman of NYU and Critical Review contributor Michael Goldberg of the U. of New Hampshire.


Admiral said...

Ummm... again, this seems like one of those overreaching criticisms of economics. The Efficient Market Hypothesis doesn't say that at all. Essentially, EMH says that information is incorporated very quickly -- not "that unfettered financial markets set asset prices nearly perfectly at their “true” fundamental value."

What a bogus claim! And it's setting up a straw man to boot: even people who believe in "strong-form" efficiency don't argue that there aren't situations when other variables might prevent it from operating in the short-run. Over a very long period, things might be different.

The claim about behavioral economists is also bogus insofar as they supposedly contradict EMH models. What a joke! Emotions create opportunities for arbitrage short-run, and LOTS of emotions simply lead to corrections in the distant future. A lot of the supposed contradictions have to do with the computation capacity of humans, and how we think, which suggests that more research should be done in neuroeconomics -- NOT that "bounded rationality" isn't true, because obviously it is, though it has limited explanatory power as currently expressed.

Indeed, the reason why government should NOT dampen such swings is because they have less information than the market does, less incentive to look out for wealth creation, and to be sure less competence. Further, it is worth thinking about whether or not a government "solution" costs more than the benefits, an idea foreign to this essay.

Anonymous said...


Frydman and Goldberg actually do use "neuroeconomics" in that they developed endogenous prospect theory (consistent with findings in psychology) to explain the excess returns puzzle in the foreign exchange market.

They are (I think) claiming that all extant models of new classical, new keynesian and behavioral economics are alike in that they rely on rational expectations. Rational expectations is very different from bounded rationality, the latter being what is actually true and what is consistent with the Imperfect Knowledge Economics or Theories Consistent Expectations in their book.

The point about unfettered markets (again I think) is merely that rational expectations and EMH have provoked the market fundamentalism and deregulation which caused the crisis. Meanwhile the policy implications of behavioral economics (or that behavioral economists have claimed) have often been contrary to new classicals, and in fact the anti-thesis, implying massive market intervention.

The argument for dampening swings (as opposed to popping bubbles as some behavioral economists argue) in their previous longer papers is not that government has more information (and indeed that is why we need markets) but that there is an externality issue in that people only care about going bankrupt and not that fact that their defaults will bankrupt others. In turn, government has a role to regulate the market and require larger capital requirements for bulls when PE ratios reach historical highs in order to lessen systemic risk from externalities during the inevitable reversal.