September 21, 2007

The Rationality of Irrational Investments

Posted in Economics at 10:23 am by Caleb Winn

In his recently-released book, and in interviews to promote said book, retired FED Chairman and economic “maestro” Alan Greenspan takes a swing at the irrationality of investors, specifically during times of rapid economic growth or decline. Money-quote:

Greenspan also turned to psychology and anthropology for explanations of economic irrationality. The erratic behavior of investors during and after bubbles—excessively exuberant on the upside, unwarrantedly pessimistic and fearful on the downside—continuously confounds economists. . .“There’s a long history of forgetting bubbles,” he writes. “But once that memory is gone, there appears to be an aspect of human nature to get cumulative exuberance.” When the bubble inevitably breaks, as reality fails to meet expectations, “the result is a dramatic 180-degree switch from exuberance to fear.”

These “bubbles,” such as the dot-com bubble of the late 1990s and the housing bubble that has recently begun to deflate, can cause rapid economic growth, but at the expense of fiscal stability. Investors all jump onto the same bandwagon, driving up prices and pouring in money until it reaches a level that is simply not sustainable. Investors are [i]too[/i] excited during times of rapid growth, and [i]too[/i] fearful during times of rapid decline, and these wild shifts in moods only exarcerbate the problems of investment bubbles. From a macro-economic perspective, this just doesn’t make sense.

Greenspan’s conclusion from this is that investors are irrational, acting emotionally, and not intelligently. In summarizing his position, MSNBC writes:

The ultimate rationalist seems to have concluded that fear, resistance to change, exuberance and human limitations play a bigger role than expected in economic development. And he recognized that economists have proven so human—i.e., fallible—in their forecasting because the force actually driving the economy is humans who are prone to act on emotion rather than reason.

Part of the problem here is that investors are pursuing short-term personal gain, and give little thought to how their actions impact the broader economic health of the U.S.. From a macro-economic level it makes little sense to create and sustain bubbles, or to yank out assets when the bottom falls out of the investment sector. As far as Alan Greenspan is concerned, that is foolish bevaiour because it is not good for the economy overall.

But for the individual investor, it is hard to resist the benefits of an investment bubble even if their actions will hurt the broader economy in the long-run. No individual investor has enormous control over the economy, and so no individual investor feels a sense of responsibility for the overall economic health of these United States. Any given individual investment has no real impact on the broader economy, but can have a huge impact on the investor. Each investor has an incentive to take a slice of the pie, but no responsibility for it, since they are only one tiny part of a much broader economic system, and their choice won’t make any real difference one way or another. Because of this, investors make their choices on the basis of rational self-interest, seeking to maximize personal profit.

So while this investment pattern seems irrational from a macro-economic perspective, it may be the product of perfectly rational individual decisions. The problem lies in the fact that the decision is replicated millions of times, and what makes sense for the individual becomes catastrophically unsustainable for the economy as a whole.