Sunday, November 15, 2009

Failure of the rational economic agent?

The search for an explanation for the sub-prime mortgage bubble led financial and economic crisis leads us to debates about whether it was a failure of forms of ownership and control mechanisms - private ownership (and capitalism) Vs public ownership, markets Vs government regulation etc.

One of the arguments being made is that the crisis has exposed the weaknesses inherent in the "efficient markets" hypothesis, that underpins both modern financial and real economy markets. That the markets cannot always efficiently allocate resources among competing investment alternative, is amply demonstrated by the sub-prime mortgage bubble. But, as Chris Dillow points out, this line of reasoning runs into problems with the recent happenings in the financial markets - you can't beat the market on a consistent basis (thereby confirming EMH), but prices deviate massively away from "fundamentals" (or the presence of fat tails, going contrary to EMH).

In another post, Dillow points to two specific reasons for banks failure to self-regulate - rational self-interest led individuals to create and hold "toxic assets" that jeopardized the interests of banks’ owners, and chief executives lacked the knowledge (or ability or incentives) to control a complex sprawling bank. Interestingly, these reasons are the same as that we commonly attribute to government failures - bureaucrats failing to act in the public interest, and central planners lacking the knowledge (or ability or incentives) to control the economy!

I am inclined to go with Dillow's argument that the only way to explain this is by reasoning that markets and institutions, both public and private, are populated by individuals, who are themselves constrained by "bounded rationality" and often prisoners of their own vested interests. In the first case, even if markets are not efficient, bounded rationality constrains traders from profiting from small and minuscule mis-pricings and profiting from fleeting opportunities.

There is another argument that the financial crisis is an indictment of traditional capitalist ownership structures and not free markets. This is explained by the moral hazard and information asymmetry inherent in the principal-agent model modern financial institutions, and the difficulty in managing complex financial instruments and markets. While the former is related to the conflict between the self-interest of the managers and that of shareholders, the latter is a natural consequence of the bounded rationality of human beings.

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