Rational expectations and impulse control

The awarding of the Nobel prize in economics to Thomas Sargent raises interesting questions how about how individuals and groups think about the future. The prize, for the theory of “rational expectations,” proposes that in the aggregate large groups of people, come to a shared and reasonable understanding of the future of some economic variable, for example inflation or exchange rates.

This theory is a version of the “wisdom of crowds.” The price of a company’s publicly traded stock, it suggests, reflects all the available information about the company’s prospects. This is why for example, day to day movement in share prices are close to random. The only new information that can change the price of a stock is by definition unconnected to current knowledge, and therefore will have no systematic effect on the stock’s price. If the effect were systematic, so the argument goes, it would have been anticipated.

This feels like a heady conception, connected more to data than to experience, though it is rooted in the not unreasonable idea that “common sense” will prevail. The term “prevail” is key however. There are periods when common sense is not sensible, for example in market bubbles, when even the “smart -money” has to follow the crowd if it wants to participate in the rewards. Intelligent investors, who identified early, the high tech stock bubble at the turn of this century, and sold their high tech stocks, underperformed the market for several years. It takes time for common sense to assert itself, and in the interregnum the objective facts matter less than other peoples’ opinions. The wisdom of crowds takes a back seat to crowd psychology.

The question then becomes when is a crowd rational and when is it irrational. The common conception of crowds as irrational is based on the idea that people feel less inhibited in a crowd because they are anonymous. We have impulses which if expressed would be gratifying, but we know that expressing them would get us into trouble by inducing guilt or provoking retaliation.  The anonymity protects us.

Freud suggested a twist on this conception. We identify with a leader of the crowd who promises to release us from our inhibitions, as long as we agree to put our impulses in the service of his goals. We remain subordinates, but this time to our leader rather than to our conscience. So the dividing line between the wisdom of crowds and the crowd as mob depends on when and whether impulse control is weakened. This is why we associate market bubbles and their collapse with fear and greed, two very strong impulses.

Researchers like Thomas Sargent who believe that the market is efficient, rightly suspect that the literature on “cognitive bias” is only of secondary importance. Common sense will prevail -- except of course when fear and greed do.