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On Economic Rationality, Bubbles, and Macroprudence

From the All about Finance by Biagio Bossone:

(Non-)rationality in economic decisions

As last year’s choice of the Nobel award for economic sciences well reflects, economists are deeply divided as to whether, and how, rationality should be modified as a basic assumption for modeling asset allocation and pricing decisions.

The three Nobel laureates for 2013 — Eugene Fama, Lars Peter Hansen, and Robert Shiller — epitomize the economics profession’s broad spectrum of positions currently existing on the subject: from Fama’s unflinching faith in the full rationality of economic action to Shiller’s recognition of the influence of non-rational and irrational factors upon human economic determinations, passing through Hansen’s acceptance of “distorted beliefs” as explanations of some otherwise inconsistent economic behaviors empirically observed.

The unresolved differences bear on the scientific status of contemporary macroeconomic analysis, especially since the crisis of 2007-09 has demonstrated the inadequacy of its underlying microfoundations. Particular attention has since been placed by economists on what they really know about asset bubbles, as these cannot be endogenized within purely rational choice models, and policymakers have re-considered whether bubbles can (or should) be managed in the public interest.

(Ir)rationality and bubbles

In fact, while it is unnecessary to abandon the rationality hypothesis to understand real-world economic phenomena, and financial crises in particular, combining human rational thinking with changing emotional states should feature prominently in the economics research agenda both to gain a deeper appreciation of real decision-making processes and to design policy tools that can re-orient individuals’ decisions, when necessary, toward superior public good objectives.

This is what I have tried to do with the general utility-based approach to asset allocation and pricing, which I have recently developed to study agents’ responses to shocks when expectations reflect the interaction of knowledge and changing market sentiment.

The approach rests on three building blocks:

  • All assets deliver utility. Assets of all types are considered as “vehicles” to future consumption, each characterized by its own peculiar “speed” (that is, the immediacy and the cost of converting it into consumption) and “power” (that is, its capacity to accumulate and store wealth over time at some risk). Greater speed would come at some power cost, and vice versa. Also, at each instant the agent would be faced with the likelihood of having to liquidate the asset to face a consumption shock: changes in likelihood affect differently the utility from asset with different speed and power load. The instantaneous utility of every asset is thus calculated through the agents’ time-horizon as the expected value of the discounted summation of stochastic (uncertain) consumption utility, to which the asset gives access, net of the (uncertain) consumption utility lost to the asset liquidation cost.

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