Celebrating the Irrational

Three cheers for the new Nobel laureates in economics: Daniel Kahneman of Princeton University, and Vernon Smith of George Mason University in Virginia. Like many Nobel prizes, these awards recognize not only the seminal work undertaken by Kahneman and Smith, but also the schools of thought they help to lead.

Kahneman, a psychologist, has demonstrated how individuals systematically behave in ways less rational than orthodox economists believe they do. His research shows not only that individuals sometimes act differently than standard economic theories predict, but that they do so regularly, systematically, and in ways that can be understood and interpreted through alternative hypotheses, competing with those utilized by orthodox economists.

To most market participants - and indeed, ordinary observers -- this does not seem like big news. Wall Street brokers who peddled stocks they knew to be garbage exploited the irrationality that Kahneman and Smith exposed. Much of the mania that led to the bubble economy was based on exploiting investor psychology.

In fact, this irrationality is no news to the economics profession either. John Maynard Keynes long ago described the stock market as based not on rational individuals struggling to uncover market fundamentals, but as a beauty contest in which the winner is the one who guesses best what the judges will say.