The Inevitable Increase of Irrationality (more musings on the recent financial crisis)

In a recent email dialogue with my dad, I found myself spouting off again about the possible causes of the recent financial crisis ... and found myself coming to a conclusion that may have some more general implications as we move forward toward Singularity.

Basically, I came to the conclusion that the financial crisis can be interpreted, in part, as a failure of the "rational actor" model in economics.

And furthermore, it's a failure of the rational actor model for an interesting reason: technology is advancing sufficiently that the world is too damn complex for most people to be rational about it, even if they want to be.

And this situation, I suggest, is likely to get worse and worse as technology advances.

Greenspan said something related in an interview shortly after the credit crunch hit: he said was shocked that major banks would deviate so far from rational self-interest.

To the extent this is the case, the recent crisis could be viewed as a failure of the rational-actor model -- and a validation of the need to view socioeconomic systems as complex self-organizing systems, involving psychological, sociological and economic dynamics all tangled together ... a need that will only increase as technology advances and makes it harder and harder for even smart rational-minded people to approximate rational economic judgments.

As a semi-aside: In terms of traditional economists, I'd say Galbraith's perspective probably accounts for this crisis best. He was always skeptical of over-mathematical approaches, and stressed the need to look at economic mechanisms in their social context. And of course, Obama's proposed solution to the problem is strongly Galbraithian in nature (except that Galbraith, not being an elected official, had the guts to call it "socialism" ;-)

Now, there is (of course) a counterargument to the claim that the recent financial crisis indicates a failure of the rational actor model. But one can also make a counter-counterargument, which I find more compelling.

The counterargument is: the banks as institutions were perhaps being irrational, but the individual decision-makers within the banks were being rational in that their incentive structures were asymmetric ... they got big bonuses for winning big, and small penalties for losing big. As a human being who is a banker, taking a huge gamble may be rational, if you get a huge bonus upon winning ... and upon losing, just need to go find another job (a relatively small penalty). So in that sense the individuals working in the banks may have been acting rationally ...

Yet the corporations were not acting rationally: which means that the bank shareholders were the ones not acting rationally, by not constraining the bank managers to put more appropriate incentive structures in place for their employees...

But why were the shareholders acting irrationally?

Well, I suggest that the reason the bank shareholders did not act rationally was, largely, out of ignorance.

Because the shareholders were just too ignorant of the actual risks involved in these complex financial instruments, not to mention of the incentive structures in place within the banks, etc.

We have plenty of legal transparency requirements in place, so that shareholders can see what's going on inside the corporations they invest in. But this is of limited value if the shareholders can't understand what's going on.

So, getting back to rational actor theory: the novel problem that we have here (added on top of the usual human problems of dishonesty, corruption and so forth) may be that, in a world that is increasingly complex (with financial instruments defined by advanced mathematics, for example), being a rational economic actor is too difficult for almost anybody.

The rational-actor assumption fails for a lot of reasons, as many economists have documented in the last few decades ... but this analysis of the current financial crisis suggests that as technology advances, it is going to fail worse and worse.

You could argue that this effect would be counterbalanced by the emergence of an increasingly effective professional "explainer" class who will boil down complex phenomena so that individuals (like bank shareholders) can make judgments effectively.

However, there are multiple problems with this.

For one thing, with modern media, there is so much noise out there that even if the correct explanations are broadcast to the world on the Web, the average person has essentially no way to select them from among the incorrect explanations. OK, they can assume the explanations given in the New York Times are correct ... but of course there is not really any objective and independent press out there, and "believing what the authorities tell you" is a strategy with many known risks.

And, secondly, it's not clear that the journalists of the world can really keep up with developments well enough to give good, solid, objective advice and explanations, even if that is their goal!

So we can expect that as Singularity approaches, the rational-actor model will deviate worse and worse from reality, making economics increasingly difficult to predict according to traditional methods.

Some folks thought that increasing technology would somehow decrease "market friction" and make markets more "efficient" ... in the technical sense of "efficiency," meaning that everyone is paying the mathematically optimal price for the things they buy.

But in fact, increasing technology seems to be increasing "market incomprehensibility" and hence, in at least some important cases, making markets LESS efficient ...

But of course, making markets less "efficient" in the technical sense doesn't necessarily make the economy less efficient in a more general sense.

The economy is, in some senses, becoming fantastically more and more efficient (at producing more and more interesting configurations of matter and mind given less and less usage of human and material resources) ... but it's doing so via complex, self-organizing dynamics ... not via libertarian-style, rational-actor-based free-market dynamics.

Interesting times ahead....