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53 responses to “The limits of market rationality”

  1. Mark Bahnisch

    Tony Blair’s book *is* very strange!

    Meanwhile, here’s Krugman on the ‘rationality’ at work in the Eurozone:

    http://krugman.blogs.nytimes.com/2011/08/08/wonking-out-about-the-euro-crisis-very-wonkish/

  2. uniqerhys

    “And states who might wish to continue to stimulate demand would have to borrow further from… markets.”

    Or raise revenue by taxing the rich and big business. The mere hint of which also causes markets to jump off a cliff. I’m getting tired of the “we can’t go further into debt” shtick from the austerity crowd, when the same crowd also opposes government attempts to raise revenue. The inmates are truly running the asylum – anything that would fix the problem is considered “economically irresponsible”.

  3. Katz

    It might be clarifying to define what one means when one speaks of “markets”. At base “markets” are composed of folks with access to funds meeting with folks who wish to borrow those funds.

    Sometimes, those folks with funds lend to folks who can’t repay.

    Oddly, the US government, the world’s biggest debtor, can still borrow on the world’s best terms. And it is. Is this “irrational”? Perhaps. But I can state with utter confidence that if lenders began to act “rationally” and began to ration funds to the US government, then the entire edifice of credit would collapse. The US government is the ultimate entity “too big to fail”.

    Is it “rational” to allow this situation to develop in the first place? The alternative is to follow the Greenspan recipe and crank out barrow loads of funny money backed by government bayonets.

    Would that be “rational”?

  4. Jarrah

    “The meltdown that followed the end of the credit and housing bubbles was addressed by governments stimulating demand. All very Keynesian.”

    Addressed? The stimuli have arguably all been failures.

    “So we now have the situation where ‘markets’ have demanded, and got, austerity economics. But that has led to continued economic gloom.”

    If the gloom has been continuing, why do you think piffling reductions in spending which are hardly worthy of the name austerity are the cause?

  5. Tyro Rex

    The Market “rationally” address the downgrade in American credit by BUYING American credit. Bond markets have rallied (yields are down) – but stocks fallen. This is classic irrational fear stuff.

  6. Wantok

    If pre-commitment works with those addicted to pokies perhaps we should introduce it in share markets and try to stamp out this irrational and very damaging indulgence.

  7. Tyro Rex

    I put a comment here it seems to have disappeared?

    [Now @ 5. It went into spam – ed]

    Anyway the “rational” market last night – as expected – decided to respond to the US credit downgrade by rallying the Bond market – that is, they bought US Govt. debt. The market is a big, irrational, fearful child. you have to play it like one – and discipline it like one.

  8. Occam's Blunt Razor

    @6 – they bought bonds because they were dumping stocks. While the bonds have been downgraded by one of the ratings agencies they are inherently safer than stocks. Gold went up as well. This is completely rational behaviour.

  9. Occam's Blunt Razor

    Short term government spending can have an impact but long term economic growth depends on the private sector investing and employing. In order to invest and employ a business needs to have a view about making future profits and keeping them. Raising taxes is completely anti-growth and therefore anti-recovery. Heavily indebted governemnts need to cut taxes and cut spending by more than the intial loss of revenue in order to move towards surpluses and debt reduction.

  10. Nickws

    The good news for us Keynesians is that David Cameron is totally screwing up the whole anti-Keynesian-but-with-a-progressive-face electoral project.

    Okay, maybe that isn’t the best news if what it does is embolden your Tony Abbotts to double down on pure social divisiveness in order to achieve their ends.

    All in all this really is a race to the bottom for the marketeer ideologues. At least both Cameron and Blair are sane enough to endorse carbon pricing in Oz, but then again anti-Keynesians-with-progressive-faces tend not to have any room to reject the hard sciences, even if they are doing a job on the dismal one.

  11. Peter Whiteford

    Jarrah

    So was the Chinese stimulus package a failure? And what is your assessment of Singapore’s stimulus package?

  12. Occam's Blunt Razor

    The Europeans telling us that having a CO2 tax is a good thing for us is like us telling them they should play more Aussie Rules Football.

  13. Tyro Rex

    Yes Razor, it’s totally rational to buy the form of debt that the debt-rater just downgraded (actually I think it is “rational” because the debt-rater is talking out their arse, but that’s another story, most of the market participants seem to completely spooked by the debt downgrade and are irrationally selling off one asset to buy the downgraded one).

    However, I used to work in financial markets. To describe them as “rational” is about as far from the truth as you can get. Greed and fear rules.

  14. Darryl Rosin

    Tyro, I think things look substantially more rational if the market participants are panicking about US growth rather than US solvency.

    d

  15. Darryl Rosin

    “In order to invest and employ a business needs to have a view about making future profits and keeping them.”

    OBR, that’s exactly the point and you seem to be missing it. No customers = no income, let alone profit.

    d

  16. Mark Bahnisch

    Yep, the point is to create or stimulate demand when it’s absent or weak.

  17. Tyro Rex

    “Tyro, I think things look substantially more rational if the market participants are panicking about US growth rather than US solvency.”

    Darryl, yes it would, except “panick” and “rational” aren’t usually overlapping concepts… and US Growth? Really? Its sluggish but not absent. I think it’s all pretty much herd mentality at the moment. Someone thought they spotted a lion somewhere so the wildebeest have stampeded for the exits.

    Anyway, the stock market isn’t the economy – if you ask me it’s a lagging indicator …

  18. Darryl Rosin

    Tyro, well, sometimes panic is the rational response :^) but probably ppor choice of word by me.

    I think US growth is going to get absent pretty soon. There’s a lot of private de-leveraging to come.

    d

  19. John D

    If you are a day carbon trader “rational” is driven by expectations of what the permit value will be in an hours time. Taking account of something as irrational as groupthink is pretty rational under these circumstances.
    If you are investing in renewable electricity “rational” is driven by long term sales and price expectations. It gets a bit scary for potential long term investors when future return on investment will depend on the “rational” behavior of day traders and hedge funds.

  20. John D

    In process plant control systems there is a trade-off between stability and quick response. If the response is set too fast the system doesn’t settle down because the response is always overshooting. On the other hand, if the response is too low, the system doesn’t react as fast as required when there is a large disturbance to the system. Modern control systems have various sophistications that improve the stability/speed trade-off. But they don’t completely eliminate the need for trade-offs.
    Part of the current problem is that some of the key markets in the world economy are becoming faster and faster. Even worse, many of the trades are run by computer programs with no human intervention. Even worse these programs use similar algorithms so once the market starts to move all these logarithms will be pushing it in the same way. A recipe for instability.
    One of the features of a lot of business decisions is that what is rational at a micro level can be disastrous at a macro level if everyone is moving the same way. (A small business can boost profits by cutting wages. A widespread wage cutting may damage business by shrinking the market.)

  21. wizofaus

    Out of curiosity, does anybody know whether tax levels were changed in Italy in response to the GFC? It’s hard not to wonder if the EuroZone’s situation would be better now if Italy and Spain had tried to focus more on balancing the books rather than explicit stimulus – I assume both Italy and Spain follow the usual practice of most European nations in paying out unemployment benefits commensurate with recent income, which would itself act as a sort of reactive stimulus as recession hit.

  22. Peter Whiteford

    As I read this – http://www.oecd.org/dataoecd/3/62/42421337.pdf
    Italy had no explicit stimulus package at all – but the fall in tax collections and the increase in benefit payments had a larger negative effect on the deficit than did Australia’s stimulus package. Spain had a smaller stimulus package than Australia but a larger increase in the deficit, due to the negative effects on growth.

  23. wilful

    Oddly, the US government, the world’s biggest debtor, can still borrow on the world’s best terms. And it is. Is this “irrational”? Perhaps. But I can state with utter confidence that if lenders began to act “rationally” and began to ration funds to the US government, then the entire edifice of credit would collapse.

    Well the underlying logic and rationality is that the US Government is supposed to be able to raise taxes.

  24. Katz

    Yes Wilful.

    The US has the ability, but not the will, to tax itself towards a more balanced budget.

    The underlying assumption of your comment is that lenders believe that there will come a time when the US overcomes its unwillingness to tax itself.

    The questions are if and when and how this day will arrive.

    Keynes famously observed that markets can remain irrational longer than you can remain solvent.

    But can politicians remain obdurate longer than markets can remain rational?

    My guess is that politicians can.

  25. Occam's Blunt Razor

    Dear PM and Treasurer,

    How’s that surplus forecast looking?

    Yours faithfully,

    OBR

  26. Russell

    Isn’t the real problem in the U.S. that the economic model of the last 30 years – the one that seems ‘natural’ – doesn’t work?

    A government ‘stimulus’ is only kicking the can down the road – eventually an economy which off-shores so many jobs and tax-paying businesses, and which doesn’t pay the middle and working class enough to create much of a demand, which doesn’t invest enough in infrastructure to maintain a comparative advantage, is going to fail.

    The problem is as much a political one as an economic one. We’re waiting for a new ‘vision’ of how to go forward, while confronting the challenge of moving to a low carbon economy. So far, things don’t look promising.

  27. Occam's Blunt Razor

    @15 – you say “no customers” – are you predicting total economic collapse?

    Reducing taxes – business sees ability to make more profit, is prepared to both invest and employ in order to make more profit – more people employed directly and indirectly means more spending and tax revenue. (And, no, I do not advocate zero taxation or zero government expenditure).

    Lenders see lower tax rates – see more profitabiltiy in businesses – more likely to lend – leads to more investment . . .

    It is ridiculous that so many Australians are reliant on government for either their job or welfare payments. The sooner the overall reliance on Government is reduced the better.

    I have said it before, this death by a thousand cuts is stupid – Bush erred in not letting the banks fail – Obama should never have propped up the US Car makers. If they had of allowed the markets to take their medicine then we wouldn’t hav a US Government with nearly as huge and growing debt levels. And don’t rol out the “it would have been so much worse” lines – the US economy is at almost 10% unemployment despite the spending – and Obama promised less than 8%.

  28. Russell

    Razor,

    Where would the demand come from? Demand was apparently coming from people using credit or equity in their inflated-value houses etc. Where is demand going to come from now?

  29. quokka

    #20 John D

    Interesting piece here on HFT in the US SPX emini futures and the activities of algorithmic traders driving away liquidity which can lead to more volatility:

    http://ftalphaville.ft.com/blog/2011/08/08/646276/hft-is-killing-the-emini-says-nanex/

    On the other hand volatility itself can and does also drive away liquidity as traders reduce their risk exposure. I really don’t know how much effect HFT has. Just one factor among many, I suspect.

  30. Russell

    Razor: “It is ridiculous that so many Australians are reliant on government for either their job or welfare payments”

    Well, we do want health care available to all, and we don’t want work-houses etc etc., so the size of our government is the price for a civilised society.

  31. Fran Barlow

    OBR said:

    It is ridiculous that so many Australians are reliant on government for either their job or welfare payments. The sooner the overall reliance on Government is reduced the better.

    Your language (the concept of reliance) shows this is a cultural claim rather than one from mere utility. The implication is that the work they are doing is of little value or unproductive merely in virtue of the fact that the state is contracting the work. This simply isn’t accurate. Doubtless, there are functions carried out by the state which wouldn’t be warranted by their utility to the community as a whole, but this is the case for private business as well. Business, regardless of whether it succeeds or fails is typically also the target of community subsidy of one kind or another, so the boundaries between state and private enterprise are far more muddy than right of centre libertarians often suggest.

    I have said it before, this death by a thousand cuts is stupid – Bush erred in not letting the banks fail – Obama should never have propped up the US Car makers. If they had of allowed the markets to take their medicine then we wouldn’t hav a US Government with nearly as huge and growing debt levels.

    This is far too sweeping and glosses over some quite complex sets of interest. It’s impossible to imagine the usages of US life withstanding the collapse of its financial system, unless of course a new one immediately arose pheoenix-like in its place. The effects of allowing the banks to simply collapse (without a ready replacement lined up) would be the figurative equivalent of the economy suffering what humans call a stroke. Tens of millions of people would in short order have been in desperate circumstances. Most people would not have been able to have been paid wages, suppliers who were major net creditors would have had to close and large parts of government would necessarily have had to stop as well. Banks are a vehicle for payment after all. So “just let them fail” is an impressively moral slogan, but it’s simply not practicable, because the knock on costs would be utterly unacceptable.

    By all means, the state might have bought their residential and other assets at firesale price, underwritten the maintenance of banking services and the security of savings and other ordinary banking accounts and set up a new federal bank to step in to ensure that people could trust that they would be paid, and typical clearing of debts could continue. Those taking the “hair cut” would be the equity holders in the banks, rather than the depositors or those using banking services.

    In the case of “Big Auto” as it turns out, the government assistance has AIUI largely been repaid or soon will be, with interest. They are paying taxes. Mass job losses have been avoided. It’s not a serious factor in US balance sheets. That said, I’d have been inclined to have extracted better terms for the assistance, but that is a separate argument.

  32. Occam's Blunt Razor

    @28 – only some of the demand is from the wealth effect of rising house prices. Given 95% of those who want work have it there is a still a large amount of demand unless you think there is a zero level of consumption spending. We have a trillion dollar GDP economy – you appear to be arguing that there is going to be no spending, which simply isn’t the case.

    @30 – there is always a budget constraint (as the Greeks are now discovering – not that we are close to that). To proclaim that publicly funded health care and all welfare benefits would be finished if Australia reduced government expenditure is scare mongering on the scale of Tony Abbott.

  33. Mark Bahnisch

    This simply isn’t accurate. Doubtless, there are functions carried out by the state which wouldn’t be warranted by their utility to the community as a whole, but this is the case for private business as well.

    … the whole panoply of team ‘coaching’ and biz consciouness raising, for instance.

    Most large corporations are in effect bureaucracies in organisational form, anyway, and the lines are much more blurred now that many state bureaucracies are corporatised.

    Given 95% of those who want work have it there is a still a large amount of demand unless you think there is a zero level of consumption spending.

    (a) Many of those who want work don’t have enough of it, and about 35% of people aren’t in the labour market;

    (b) It’s not a question of ‘zero’ demand but of a lack of effective demand. As Darryl pointed out above, selling something is also not the same as making a profit.

  34. Occam's Blunt Razor

    @33 – (b) – are you saying that there is no profit to be made or wouldn’t be if government spending was cut?

    In all the time I spent studying undergraduate economics I don’t recall the macro-economic concept of effective demand being so directly linked to the micro-economic concept of profit in the way you appear to have done so. Have I missed something?

  35. Mark Bahnisch

    Keynes!

  36. Adrien

    Gordon Brown was actually right that stimulus should have been maintained for longer, and the overweening irrationality of markets addressed at the international level.

    Was he? How do you know? I agree with Jacques Chester who made a comment on Skepticlawyer earlier that the benefits of Neo-Keynsian stimulus will be a subject for economic argument for decades.

    The GFC thing ain’t over and there’s no pure natural experiment to demonstrate empirically the relative success of Neo-Liberal and Neo-Socialist responses to the crisis. Was Australia’s stimulus, for example, necessary? After all we didn’t have the crisis that the US had. Some will argue that this is because of the stimulus. Others will argue that the stimulus just wasted money in a panic over nothing.

    Who’s right? Well get yer Book of Ideology out and there’s a new chapter that tells ya.

  37. Nickws

    Ockam’s @ 25: Dear PM and Treasurer,

    How’s that surplus forecast looking?

    Yours faithfully,

    OBR

    What with your lack of centext you better not start calling yourself OECDBR.

  38. Russell

    “only some of the demand is from the wealth effect of rising house prices. Given 95% of those who want work have it there is a still a large amount of demand unless you think there is a zero level of consumption spending. We have a trillion dollar GDP economy – you appear to be arguing that there is going to be no spending, which simply isn’t the case.”

    I’m only asking how will the U.S. economy get back to where it was, when where it was included all that credit that has now been withdrawn and won’t be coming back too soon. Real wages there haven’t risen for decades – what will make up for all those speculative homes that won’t be built, new cars bought with loans that won’t be extended etc

  39. Occam's Blunt Razor

    @37 – the ALP made the rod for it’s own back.

  40. billie

    “The limits of market rationality” – its irrational, in the end the market is a voting machine. However, the irrational market can have a very real effect on the economy and talk down our prosperity.

    Only an idiot would put their faith in the market to fairly redistribute resources and effectively raise the capital to build infrastructure that our economy relies on to function. John Maynard Keynes, who made a motza on the stock market in the 1930s, ennumerated this in his macroeconomic theories that were applied in America, western Europe and Australia from 1945 to 1970.

    Unfortunately the vandals from University of Chicago have gained favour and trashed economies in which they operated. A Chicago graduate, John Elliott used Henry Jones IXL as a vehicle to gain control of Fosters have his blaze of glory then crash and burn

  41. Occam's Blunt Razor

    @40 – the disciples of the Chicago school of Economics and Milton Friedman would beg to disagree that they have been able to gain favour. The masive levels of taxation, spending and debt in no way reflect what Monetarists beleive should happen in an economy.

    The current crisis has been caused by the problems in the credit markets – not monetarist policy prescriptions.

  42. Nickws

    the ALP made the rod for it’s own back.

    What rod? The rod of some economists warning that the new market shennanigans might keep the budget in deficit for an extra year? Oh, the horror, high finance actually has a causative relationship with GDP growth. Our public debt level may actually move closer to that of profligate Luxembourg. We’ll be rooned.

    Here’s something I found that you sould enjoy, OBR: The Wall Street Journal endorsing the idea of the Commonwealth of Australia going to town on new stimulus in the event of another GFC.

    “Bankrolling a nationwide spruce up of Australia’s infrastructure could provide a timely Keynesian stimulus to the economy in the event of a global downturn that would inevitably hit mining and resource industries, the key drivers for growth and existing investment into new infrastructure.”

    Even the WSJ!

  43. Tim Macknay

    … the whole panoply of team ‘coaching’ and biz consciouness raising, for instance.

    What makes you say this isn’t of benefit to the community?
    If you’re looking for a business practice that is of no benefit to the community, I would have thought selling tobacco would be a better example.

  44. adrian

    “@37 – the ALP made the rod for it’s own back.”

    A bit like the person who invented apostrophes.
    As for the people who can’t follow a simple grammatical rule…

  45. Darryl Rosin

    [email protected] ‘you say “no customers” – are you predicting total economic collapse?’

    No, that was just me making the point starkly. But if people don’t have money in their pockets they stop spending and the intent of government spending during these times is to get money into people’s pockets so they can start spending again. I expect most business are less concerned about their effective tax rates and more concerned about ‘where are all my customers’.

    As Mark said above: Keynes. Periods of reduced demand (recessions) are exactly the wrong time to reduce government spending. (Mostly. Let’s not get into Eurozone problems. They’re different.)

    And @32 “Given 95% of those who want work have it there is a still a large amount of demand unless you think there is a zero level of consumption spending. We have a trillion dollar GDP economy – you appear to be arguing that there is going to be no spending, which simply isn’t the case.”

    The problem isn’t *zero* spending, it’s *reduced* spending. How elastic is demand for what you’re selling? Spending = income + change in debt. If debt is being reduced faster than income is growing, spending will decrease.

    d

  46. Joe

    The problem with stimulating the economy is that it distorts the markets– the markets are no longer able to set prices based on supply and demand, which is a very significant reason for why we have markets.

    The argument is that the markets were actually distorted by the practices of the big banks using derivatives etc. but basically due to bad loan practices. These banks actually created all the debt, not the central banks. The central banks are now trying to take this too much debt out of the economy in such a way that the social effects are kept to a minimum. But the problem seems to be too big at the moment. This type of market engineering while at the same time not in some way curtailing the profit-motive of the market is in danger tearing the economy apart.

    The economy increasingly needs accountability.

  47. Tim Macknay

    If you’re looking for a business practice that is of no benefit to the community, I would have thought selling tobacco would be a better example.

    Aargh – Mark, I just remembered you’re a smoker. Just to clarify: that remark was not intended to be personal in any way.

  48. paul walter

    OBR, 41, What a serious injury to the text this particularly post is. What weaving of tautologies and complete disdain for the syllogism.
    What do you think “history” is, my brother?
    Are we getting a bit far away from Kim’s thread starter?
    What is the nature of the crisis?
    It’s another heist.. $Trillions!
    Also the bunk about the economy, let’s consider the penalties for no international reform, the US becoming plutocratic with the rich let off paying tax and the massive spending on defence maintained across the globe, not grizzle at the disadvantaged, ffs!
    Let’s not forget how this has been set up.

  49. Occam's Blunt Razor

    @42 – I’d be really interested to see the polling impact of Swannie announcing that the ALP has decided not to return the budget in 2013 to surplus as previously promised.

    Yes, that would be the right policy in the short-term if there was a significant drop in demand most probably caused by a collapse in resource investment – that hasn’t happened yet.

    @45 – exactly and the Eurozone problems are vuirtually the same as the US – it is a debt problem. It is not a classical lack of aggregate demand situation. The debt and asset pricing issues must be resolved.

    The interesting thing with the lack of consumer spending in Australia has been the historical high in our savings rate – an issue which had often been pointed out as a significant structural issue in Australia in the past.

    @46 – yes, accountability is what is required – that is what those terrible Tea Party people want – aren’t they evil!

  50. Fran Barlow

    We could also throw in gambling, Tim. Junk mail? I’d say so.Iagine if junk mail disappeared tomorrow? Would the world be impoversihed as a result?

    The more general point though is that business activity, like government activity, is largely about guesswork. The fact that the latter is largely unaccountable doesn’t sanctify it in the manner OBR implies.

  51. Fran Barlow

    oops … Imagine

  52. Tim Macknay

    We could also throw in gambling, Tim. Junk mail? I’d say so. Imagine if junk mail disappeared tomorrow? Would the world be impoversihed as a result?

    Yep Fran, I’d rate both those as of dubious social utility.

  53. Tim Macknay

    I must have forgotten to put in blockquote tags. Sorry ’bout that.