A few weeks ago, at the Baseline Scenario, James Kwak wrote a few posts about the difficulty of spotting bubbles, responding to suggestions from economist Leigh Caldwell calling for a behavioral-finance-inspired index of bubbliciousness, that Dionysian state which impels people to pitch themselves headlong into jumbo mortgages and other quixotic ventures, all in the interest of rags-to-riches self-actualization, keeping-up-with-the-Joneses “juice,” and other consumer-culture daydreams.
“Behavioural and experimental economics now provide objective ways to measure and monitor such variables as risk appetite, monetary value expectations, and cognitive capabilities of investors when evaluating financial products,” Caldwell explains. Therefore, “using known expected values, it is possible to calibrate investors against the hypothetical rational agent, and find out whether they are irrationally exuberant — or irrationally pessimistic.” That is, we can test actual investors behavior against the rational behavior neoclassical economics expects (here defined also as the normal and optimal behavior — a problematic assumption in itself) and determine their degrees of bubble-fomenting.
According to Caldwell, this procedure will give us a kind of handicap with which to adjust the prices of assets to their “true” value. “While the long-term return cannot be tested today, the irrationality of consumers can, through specific experiments,” he writes: “Thus the change in expected returns can be deduced by subtracting the irrationality effect from the actual price rise.” Further, once this “irrationality effect” has been isolated, efforts could be made to correct it through what Caldwell terms “macrorationality”:
There are many other tools which have been experimentally tested at the micro level but not yet applied to macroeconomics. Price anchoring, framing, endowment effects, confirmation bias and various social and peer effects all demonstrably allow us to influence behaviour in the lab; they should have applications to what we might call “macrorationality”.
Caldwell would like us to resolve irrational human behavior into a form that proves “mathematically tractable” — which sounds a lot like old Frankfurt-School fears about the totally administered society coming to fruition at yet another level. Macrorationality seems like a matter of circumscribing one’s possible decisions at the broadest possible point, of eliminating individual autonomy in favor of better economic predictability at the social scale. All this while maintaining the pretense that reality is not being shaped or conjured, but is simply being measured more carefully. (Caldwell himself notes the paternalism of his suggestions only quickly to dispose of them as being questions to resolve at a later date, when the state of financial regulation is not in a crisis.)
If behavior can be modeled mathematically, is it irrational any longer? Isn’t the irrational precisely that which eludes formulation? Aren’t bubbles inherently the scenarios in which the models are defunct or purposely discarded as no longer relevant to the new hyperoptimistic reality, in which everything’s different? Kwak, in hashing out the problem of gauging housing prices, notes, as many others have before him, that in any situation, “it’s generally possible to come up with a reasonable argument that things have changed this time.”
If we’ve learned anything from the past few decades, it’s that bubbles redefine what’s normal so that failure to participate in whatever Ponzi-like scheme has inflated the bubble is what registers as abnormal. If you don’t invest in internet stocks, if you don’t day-trade, if you don’t try to flip condos, if you don’t tap your home equity credit lines to reinvest in more lucrative opportunities and so on, you distinguish yourself as a wet blanket — or even, astonishingly enough, as a poor patriot.
Within capitalism as it’s currently configured, irrational exuberance will always finds its alibis. Too many suckers are structurally required. It’s a fortunate thing, then, that there’s one born every minute.