In magic or in markets, it is never rational to be wrong

142

Economists interpet rationality as consistency. But is this what is ordinarily meant by rationality – and is consistency really possible or desirable in a complex world?

Last week the anthropologist Keir Martin described on this page how Papua New Guinea farmers would plant only half their land, believing that envious neighbours might employ witchcraft if they did more. This behaviour was evidently not profit-maximising, yet made sense in the context of the beliefs and customs of Papua New Guinea.

I knew what the response would be, and it was not long in coming: Martin Cox explained in a letter that economists would regard such behaviour as wholly rational. Modern economics – and the rational choice theory that has now spread throughout the social sciences – defines rationality not as wealth maximisation but as consistency. If the tribesmen plant half their fields where there is bad juju, and all their fields when there is good juju, their behaviour is rational – so long as they adhere strictly to that principle.

Perhaps the greatest achievement of modern theoretical economics has been to show the power of that consistency assumption. If agents act on a consistent set of preferences and beliefs, a market economy will establish prices based on them. Under certain further assumptions, resource allocation in line with these prices is the best means of fulfilling these preferences and beliefs. That has been espoused by business people and rightwing politicians who would not know a fixed point theorem from a quadratic equation.

So Mr Cox makes a valid point by emphasising consistency, but in doing so gives the game away. Consistency is not what people ordinarily mean by rationality. They do not think that belief in good and bad juju is rational because consistently maintained. The common dictionary definition of rationality is “amenable to reason”, referring to the kind of ratiocination approved in the scientific west.

But surely, even if it is not sufficient to be consistent to be rational, it is necessary to be consistent to be rational? Up to a point. Consistency means that in the same situation you do the same thing: but who is to judge whether or not the situation is the same? If it is rational to plant one’s fields only when there is good juju, is it also rational to plant one’s fields only when in a good mood? If I visit the same restaurant twice, and choose different dishes from the same menu, am I being inconsistent? If I am being inconsistent, am I being irrational? To say I have a preference for variety, though true, is hopeless – you can account for any conceivable behaviour that way.

Consistency is a characteristic to be prized in a world simpler, more predictable and better understood than the one that we live in – the world described by certain kinds of economic model. In the real world, I am consistent but you are stubborn, and each of us has good grounds for thinking we are right.

This is not an obscure philosophical argument but a practical issue of considerable importance. Is the senior tranche of a mortgage-backed security that is triple A rated the same as a US Treasury stock, or different? If the two securities were priced similarly three years ago, and are priced differently now, is this because people are inconsistent, or because the facts have changed? Profit and loss in financial markets results from understanding or misunderstanding these processes.

Arbitrage trade in financial markets is possible because some people think two situations are the same while others think they are different. Securities trading usually happens because different people have different, and changing, interpretations of the same facts. That is why prices are uncertain and unstable. It is also why we are not helped by models that tell us there would be a right price for everything if there were consistent underlying beliefs and preferences.

Different social contexts lead some people to believe in juju and others to believe that the alchemy of securitisation can turn subprime mortgages into triple A obligations. The test of the rationality of these beliefs is not their internal consistency, but whether they guide us to wise decisions. By that criterion, neither scores well.

Print Friendly, PDF & Email