Wednesday, July 8, 2009

The fallacy of rational expectations

Rational expectations is how most modern economics models agents. In equilibrium, agents will choose the option that optimizes their outcome. This assumes a tremendous intelligence on the part of the human.

It is plain obvious our race does not possess this quality. Our decisions are faulty, made with partial information, based on gut instinct, sometimes just plain dumb.

Think about Ponzi type II investors. The investor speculates that the price of houses will go up, spurring demand for both credit and houses. This sparks a self feeding loop of a credit bubble and a housing bubble. This ponzi scheme is stable in the short term, even highly profitable and can go for awhile and becomes generalized (7 years?).

You will start hearing "real estate ALWAYS goes up" and other stupid things. In retrospect this is a sure sign the Ponzi is about to blow. People can rationally build up expectations that the market will go up based on short term experience and ignore the rational long-term outcome that it will blow up at some point. We blow ourselves up every time with money.

Some models represent agents as Ponzi II speculators. Just for fun I would look for papers where some agents are "dumb or random". Not everyone has a cloud of computers to pick solutions out of a 120 variables universe. Sheesh!

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