In this really outstanding post on FT.com’s Economists Forum, Roman Freedman and Michael Goldberg point out some of the essential flaws of the underlying concept of “rationality” as it is defined and used in economics:
The centrepiece of this standard of rationality, the so-called “Rational Expectations Hypothesis”, presumes that economists can model exactly how rational individuals comprehend the future. In a bit of magical thinking, it supposes that each of the many models devised by economists provides the “true” account of how market outcomes, such as asset prices, will unfold over time.
The economics literature is full of different models, each one assuming that it adequately captures how all rational market participants make decisions. Although the free-market Chicago school, neo-Keynesianism, and behavioural finance are quite different in other respects, each assumes the same REH-based standard of rationality.
In other words, REH-based models ignore markets’ very raison d’etre: no one, as Friedrich Hayek pointed out, can have access to the “totality” of knowledge and information dispersed throughout the economy. Similarly, as John Maynard Keynes and Karl Popper showed, we cannot rationally predict the future course of our knowledge. Today’s models of rational decision-making ignore these well-known arguments.
They then go on to discuss the implications of this adherence to the strict, deductive, Cartesian rational expectations hypothesis for business cycles and financial market fluctuations. These are really good and really important arguments. They also touch on the point I raised in my post last week on paternalistic regulation — if you make policy grounded in behavioral economics models that are grounded in this unrealistic rationality concept, then you will conclude that any behavior that deviates from the predictions of your model and its “perfect rationality” is irrational or anomalous. Furthermore, if you believe that some central authority can amass the knowledge to determine what that “perfect rationalilty” outcome would be, then you will empower that authority to force you to behave in that way. But if you admit to the knowledge assumptions of Hayek, Keynes, and Popper, then you have to abandon that “perfect rationality” benchmark, and recognize that comparison with this benchmark is unrealistic, useless, or even pernicious, because it leads you to undervalue the individual’s ability to determine what the best actions are to take given their local knowledge.