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Tuesday, November 25, 2008

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....


Jef said...

Wow. Sounds just like arguments to the incoherence of purported Friendly AI based on the fundamental nature of agency increasing in instrumental effectiveness but dependent on (feeding on) an environment of increasing uncertainty.

Onward with increasing awareness for increasing (necessarily local) morality!

brilanon said...

It isn't obvious how a scarcity-free economy looks through the lens of economics. Machine-controlled R&D, manufacturing and distribution might operate with such low overhead that the profit margins would be insufficient even to feed anyone in the old model. But in the new one food would be free or better!

Truly a changing time to be alive

Ben Goertzel said...

Brilanon: if we get rid of material scarcity but don't have rampant AI's yet, then it would seem that attention (from minds) will become the new currency.

Once attention becomes cheap too (due to mass production of minds and consequent cheap construction of intersubjective realities), then -- most likely -- for most minds, everything becomes a game ...

Anna G said...

Singularity – I couldn’t agree more! All institutions reflect the principles of its members therefore all are self-serving. New technologies have helped increase our interconnectedness and as a consequence the failures are massive and very complex.

Here is a 5-minute video I’ve put together with others that helps promote unity to bring about positive world change.
If this video inspires you toward bringing about positive change, then please forward it to your friends. The state of the world is intensifying, and all we want is for people to spread the message that we need to wake up.

Alberto said...

Sorry I have not mastered still your complex compexness gibberish, but I know something about economy and I know about the misuse of the monetary policy with artificialy low interest rates of Greenspan. I know about the low prices of imported goods from Asia that masked the massive inflation that this monetary policy would produce otherwise. I know the pressure of the Clinton administration for giving non rational morgages to NINJA people. I know that all made a big bubble in the housing market. I know the corruption and overlooking of the market regulators.

Perhaps these are the true causes of the crisis, not the complexity of complexness. Although as poetry it sounds well.

Complexity explain nothing because even if economy is more complex, it is compensated by more brains, more communications and more knowledge dedicated in every node of this economy. Yoy have to contemplate both sides of the equation. not one of them. To know a complex system does not guaranty to know every complex system. Each one is different.

Galbraith is not respected and was never respected by respectful economists. You need the real thing.

Ian said...

Hi Ben, I posted a link to this here.

(You may be interested in the pervious post too. )

Ian said...

Whoops the previous post link should be ....

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