August 1, 2007

Irrational Exuberance

Filed under: Economics — duncan @ 8:48 pm

But let’s accept, for a moment, the idea of individuals ‘rationally’ maximising their utility. What does this ‘rationally’ mean? What utility are we talking about? Or, to put it another way, when is this utility?

I’ve quoted it before and I‘ll quote it again. Alfred Marshall: “the element of Time… is at the centre of the chief difficulty of almost every economic problem.” Any rational economic actor is, at any moment, faced with a choice between maximising current utility, and maximising future utility. And this future utility is the utility of many futures: not just all the present moments that lie ahead of us, but all the possible presents that, in our ignorance, we can’t know we’ll ever reach. We are ignorant and we are mortal. Any plan for the future is guided by our uncertainty of what that future will be, and whether we will even be there for it.

How then are we to judge when or how to maximise our utility? Any postponement may be permanent. To make a choice faced with this ignorance is to introduce the doubt and risk that is at the very heart of irrationality – and of economics.

In a celebrated phrase, Alan Greenspan called the dot com boom an example of ‘irrational exuberance’. Faced with a booming stock market, everyone wants a piece of the action. It’s the same with any bubble – a bubble operates because we all want in on the action; and everybody knows that, so long as they get out fast enough, they can’t lose. How fast is fast enough? If our frame of reference is short enough – and why shouldn’t it be? we can make our fortunes – the most irrational economic behaviour (viewed as a whole) can be perfectly rational for any individual.

And what about the libertine, squandering life, mortgaging the future against present pleasure? Is that irrational? I’ve heard rumours to the effect that we could all be dead tomorrow.

My point (which I’ve made before) is that the only difference between ‘irrational exuberance’ and rational economic behaviour is the time-scale. And in economics there is no long-term.

“Irrational exuberance”: that’s as good a working definition of life as I’ve come across. Let’s start from irrational exuberance. Rational prudence is a derivative phenomenon.

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