Predictably Irrational

A pop quiz. Who wrote this:

"...these models do not fully capture what I believe has been, to date, only a peripheral addendum to... financial modelling - the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve."

No, that's not Dan Ariely, but Alan Greenspan.

In a piece for the Financial Times which can only be read as a triumph for behavioral economics, the Maestro calls on forecasters to account for the fact that humans and markets don't always act with Reason on their side, especially during a downturn:

Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioral responses as non-rational. But forecasters' concerns should be not whether human response is rational or irrational, only that it is observable and systematic.

The observably irrational part of the current financial crisis came to light in August when some hedge funds unexpectedly faltered: Assets that had typically moved in different directions -- allowing for hedging opportunities which helped drive profits for many funds -- started to move together, implying that liquidity was drying up. As hedge fund losses stacked up, anxiety about greater losses down the line also mounted. The market had moved from a period of "euphoria" to a period of "fear."

What Greenspan argues is that this type of reaction shouldn't catch forecasters and policymakers so off-guard in the future. But is this behavior systematic? The bank runs of the Great Depression, the failure of Long-Term Capital Management, and the demise of Britain's Northern Rock suggest that it is.

It's worth remembering that Greenspan has been heavily influenced by Ayn Rand and her philosophy of rational self-interest, which has been used by more than a few Wall Streeters to justify their big paychecks -- at least until this year. Behavioral finance and rational self-interest have never been on friendly terms, but will the idea that irrational behavior is predictable bridge these two schools of thought?

Just last month, Steve Levitt and John List of the University of Chicago wrote that as neat as the findings of behavioral economics have been over the past two-and-a-half decades, their practical usefulness has remained marginal:

Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets.

I'd like to add the financial collapse of 2007-08 as Exhibit A.