Keynes & irrationality

You can’t open a newspaper these days without seeing some article about how people behave irrationally. What much of this writing misses, however, is that - for many practical purposes - it’s just impossible to behave rationally. The distinction between actually-existing irrational people and the desiccated calculating machine of economic theory is a false one - because the latter cannot exist.
This is the point Keynes made. His argument was not that people could behave rationally if only they tried harder. It was that they behaved irrationally because there was no alternative.  He wrote:

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits.

The emphasis here should be on the word “only.” This is because rational calculation is impossible as we usually have no relevant information  about the future:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible….
Human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist.

With rationality unavailable to us, animal spirits, rules of thumb and sentiment are all we have:

In abnormal times in particular…the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

Again, we should emphasize that phrase “in a sense legitimate.” Keynes did not argue that men were always stupid:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects.

What Keynes seems to be edging towards here is a point made by Gerd Gigerenzer - that sub-rational thinking, such as folklore and rules of thumb often serves us well (pdf), especially when we lack the resources to use full rationality.
Two examples should suffice; both are in part analogous to stock market investing.
1. How do you catch a cricket ball? In theory, we could calculate its velocity and trajectory and position ourselves accordingly. But of course we have neither the knowledge nor time to make such a calculation. Full rationality is irrelevant. So we use rules of thumb such as “keep your eye on the ball” and “soft hands”.  And these often work well, unless one is Australian.
2. In a strange town, how do you decide what’s a good restaurant? You might not have the time to consult all the (possibly unreliable) restaurant guides.  The rule of thumb “choose a busy place - the locals might know something” will often do well; sometimes at least, there is wisdom in crowds. In this sense, Madeleine Bunting’s claim that we are lazy and imitative misses the point - being lazy and imitative needn’t be a bad thing. 
Saying that “people are irrational” is rather like saying “John Prescott is fat and ugly”. It’s true but unoriginal and uninteresting: I’m astounded that Maddy thinks otherwise. The questions are: can we identify in advance when irrationality will harm us? And in such cases, is it possible to do better?

Comments

[Deanos]

Two more years of this Aussie bashing...

Noooooooooo, it is only just beginning!

[Dave Weeden]

As you haven't defined "rational behaviour", it's very hard to say what behaviours aren't rational. The assumption seems to be something like "gather all possible information and carefully process it". The problems with this include knowing when all possible information has been gathered (and whether one can decide this using our 'rational' heuristic) and knowing what kind of processing is suitable.

There isn't actually any such thing as "rational behaviour". Self interest? Self interest of our genes? Who is to say which is paramount if either? Rationality is *conditional*.

I think you're wrong about the cricket ball thing. We can actually make pretty good calculations about velocity and trajectory on the fly; the time required is not very much at all. It's true that most cricketers can't do the maths, but they do formal maths and ball catching with different parts of their brains. You probably can't talk cogently about Chomskian grammar either, but you can write grammatically.

Anyway, I think I agree with you - apart from adding to your observation "it's unoriginal and uninteresting" "it's wrong too".

[Glenn]

The scientists might argue that this is the why economics is such a poor relation to the pure sciences.

But scientists use rules of thumb and instinct to guide their experimentation and understanding too.

Having said that - as an economist, I come across some mindsets which are just plain wrong, and are 'myths' rather than 'folklore'. In this way, some 'irrationalities' can become accepted orthodoxies, even though they contradict observed behaviour or strong research findings. The world of economics and economic policy is riddled with them...

[herbal drug]

That article is refers to the persons who are behave irrationally. That article is worth reading for that kind of people.

[Alex]

"The rule of thumb “choose a busy place - the locals might know something” will often do well; sometimes at least, there is wisdom in crowds."

Not necessarily:

http://en.wikipedia.org/wiki/Herd_behaviour

[replica rolex]

And a lot of it reflects a switch from bank deposits to securities; foreigners “other investments” in the UK, http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html

[reverse cell]

I have a hard time believing in such things as being rational, and sometimes even logical. I think they bring the world to a halt because it makes us dependent on the expected.

[phentermine 37.5]

There is a lot of merit to what you're saying. I suppose regulatory measures--in a lot of ways, similar to corrective keynsian measures--also presuppose that the "only" problem with the financial crisis rests with the private sector, or the fact that "irrationality pervades human behavior and information asymmetries are abundant. . . ." My question was meant to also stimulate discussion on whether distortions in the economy's capital structure--which can almost all be attributed to government fiscal and monetary policy--essentially set the foundation upon which this "irrationality" thrived. That is, while I realize there were problems at every level, perhaps by focusing solely on the private sector, we are ignoring the core illness of distorted demand for long-term capital.

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