Bubbles: Who Was Rational, Who Was Not?

Can a mass delusion be instrumentally rational? No. But it could be rational to strategically profit from other people’s stubborn delusion that house prices always rise. Another question: within the confined mental space of a delusion, is there still a choice for the deluded person to be or not to be rational in responding to their false belief? Again the answer is probably ‘no’, but this time there is a story to tell.

The collapse of the US subprime mortgage market in 2008 was the trigger for a wider crisis that is ongoing in the developed world. The wave could not have spread in the way it did if there had not been numerous other economic and political fragilities. Maybe all the vulnerabilities share a common feature -- deficiencies of rationality.

A paper (pdf) on the mortgage foreclosure crisis written ten months ago by Boston Fed researchers provides the insight. It questions the usual arguments that collapse resulted from inadequate information, misaligned incentives, or new financial innovations which led to dangerously complicated securitization and derivatives. It argues that the information was available, the models were basically working well, the warnings about subprime and house prices were very public and difficult to ignore, and managers of the relevant financial institutions did have ‘skin in the game’.

The authors argue that “borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices … Higher house price expectations rationalise the decisions of borrowers, investors, and intermediaries -- their embrace of high leverage when purchasing homes or funding mortgage investments, their failure to require rigorous documentation of income or assets before making loans, and their extension of credit to borrowers with histories of not repaying debt. If this is true, then securitization was not a cause of the crisis. Rather, securitization merely facilitated transactions that borrowers and investors wanted to undertake anyway.”

“A bubble … rationalises the decisions of borrowers”.

From a rational risk perspective three key facts stand:
1. Mortgage investors had lots of information.
2. Investors understood the risks.
3. Investors were optimistic about home prices.

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Mass delusion explains why investors massively purchased loans that were forecast to perform badly if prices declined. Pessimistic scenarios were assigned very low probability. Mortgage market ‘insiders’ wilfully believed, contrary to a lot of expert evidence, that house prices would continue rising. In fact, “executives most likely to understand the subprime lending process had made personal investment decision that exposed them to subprime risk”. A few lone ‘outsiders’ made billion dollar fortunes by performing “old-fashioned bank credit analysis” using publicly available information, and betting on a fall in house prices.

The authors say they sympathise with the view that bubbles are inevitable given the psychologies of belief distortion, but that precautionary saving, financial fire drills, and stress testing would help minimise the impacts and the subsequent costs of recovery.

The sociologist, in contrast, would be sceptical that any rationality was in evidence. Incentives were misaligned, but at a higher level of abstraction. The potential sources of rationality lay in areas where risk behaviour is mediated by ultimate ‘belief’ not in house prices but in precedents of legal and governmental safety nets. In order to begin bringing the distorted expectations back down to earth, it would help if -- in the words of the Boston Fed authors -- future borrowers were routinely told about the good “chance that the house will soon be worth substantially less than the outstanding balance on the mortgage”.

Extending the concept of rationality to the confined mental space of a delusion is a misuse of terminology. The delusion is the bubble. Rationality is the mechanism for conquering delusions in the same way that rationality vanquished magic. Rationality bursts bubbles.

The ‘rational’ actors were the ‘outsiders’, because they did their calculations.

To be rational is to deliberately make an effort to accurately calculate optimum means to ends. A delusion would be an error and a deviation. The evidence in the Boston Fed paper shows that profit-seeking insiders in mortgage markets did not assemble the information, and did not do the calculations. The profit-seeking outsiders did. Insiders did not want to perform the task because they thought they did not need to. They deluded themselves. It is not rare for managers in large firms who are over-confident about their ability to control outcomes to reject data that does not confirm their optimism. Managers usually do not think like statisticians.

Another characteristic of rationality is that it takes time; time set aside to collect data and process calculations. In economic behaviour, especially in financial markets where dangers and opportunities come and go rapidly, time devoted to rationalisation can mean postponement and loss.

The concept of rationality is certainly relevant to analyses of market behaviours and corresponding government policies, but probably more as a method of defining what not to expect. Analysis of rational decisions should be a precursor of actions that routinely, through habit, anticipate and avoid fragility by prudence, precaution, and risk-spreading; not to immunise against error, but only to make the error bearable.

With regards to the economic sociology -- the systems theorist Niklas Luhmann said that “variable prices make all economic behaviour a risk … any effort to achieve rationality shifts the centre of gravity towards impracticability, thus condemning itself to failure”.

In conclusion, discussion of rationality is not terribly relevant to the mortgage foreclosure crisis. The fact that investors and borrowers possessed the information and understood the risks yet remained optimistic has little to do with rationality. It could, however, reinforce an argument -- on grounds of natural justice -- that those people deserve their losses and should not be compensated. If we thought they were behaving rationally, we might be inclined to forgive the massive losses which their actions caused to us.

Arguing about concepts can be a useful step to understanding, but only a first step.

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