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.”