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Rationality and the Free Market Economy

Economics / Economic Theory May 18, 2010 - 08:07 AM GMT

By: Douglas_French


Best Financial Markets Analysis ArticlePeople seem to do the craziest things when it comes to money. Whether it's chasing stock-market bubbles or paying good money after bad on a home that's hopelessly underwater, the idea of individuals acting as homo economicus seems far-fetched. Only in the ivory-tower world of rational-expectations theory does one find perfectly rational humans making judgments using all available information to satisfy their subjective ends.

In Epistemological Problems of Economics, Ludwig von Mises explains that the homo economicus would be the perfect businessman, conducting an enterprise for maximum profit:

By means of diligence and attention to business he strives to eliminate all sources of error so that the results of his action are not prejudiced by ignorance, neglectfulness, mistakes, and the like.

Does that sound like your know-it-all neighbor or blowhard brother-in-law? Not hardly. Michael Shermer explains in The Mind of The Market: Compassionate Apes, Competitive Humans, and Other Tales From Evolutionary Economics that behavior that is irrational today may have been perfectly rational a hundred years ago and that the work of evolutionary psychologists is needed to explain human decision making. The rational being practicing rational-expectations theory only makes behavioral economists laugh. And the neoclassical construct of equilibrium prices requires assumptions that only tenured professors who don't get out much could believe, like perfect competition, perfect information, and perfect rationality.

Mises wrote,

It did not escape even the classical economists that the economizing individual as a party engaged in trade does not always and cannot always remain true to the principles governing the businessman, that he is not omniscient, that he can err, and that, under certain conditions, he even prefers his comfort to a profit-making business.

But as messy as human decision making is, the spontaneous order leads to an extraordinarily productive economy and Shermer makes the case that "just as living organisms are designed from the bottom up by natural selection, so too is the economy designed from the bottom up by the 'invisible hand'."

Shermer cites a number of experiments that show real human decision making. If you've read any evolutionary psychology, the experiments will be familiar. For instance, decision by decision, most humans instead of being rational are risk averse. Most folks will only take a fifty-fifty chance when the payoff exceeds double the potential loss. Humans are "twice as motivated to avoid the pain of loss as we are to seek the pleasure of gain." Groupthink is very powerful, with Solomon Asch's studies showing that people will decide wrongly 70 percent of the time when influenced by a crowd. Studies of MRI brain scans confirm a correlation between decision making and reward. Trust and social interactions are tested using the prisoner's dilemma, while dopamine neurons are released when rewards are greater than expected.

Dopamine plays a prominent role with investors who take increasing amounts of risk to achieve the kick of gains made through speculation. Drugs and sex also feed the dopamine neurons, and so "do addictive ideas, most notably addictive bad ideas, such as those propagated by cults that lead to mass suicides (in the case of Jonestown and Heaven's Gate), or those propagated by religions that lead suicide bombers to commit mass murder (in the case of Islamic militant extremists)," Shermer explains.

So are the bulk of humans acting (what some would classify as) irrationally at least some of the time because we can't help it — because our brains are wired that way? Maybe there is no distinction between rational and otherwise. Mises wrote that there is only purposeful behavior or human action. "Praxeology does not employ the term rational," Mises wrote in Money, Method, and the Market Process, explaining that the "opposite of action is not irrational behavior, but a reactive response to stimuli on the part of the bodily organs and of instincts, which cannot be controlled by volition."

In Mises's view, economics doesn't deal with homo economicus at all, but with homo agens: man "as he really is, often weak, stupid, inconsiderate, and badly instructed," or, in other words, the human behavior described in Shermer's book.

In the new book, Rothbard vs. the Philosophers: Unpublished Writings on Hayek, Mises, Strauss, and Polanyi, Rothbard takes his mentor Mises to task for this view, writing of Mises's view that the use of medicine men employing magic for curing disease or rainmaking in the Middle Ages was not irrational, because it was purposeful action. Rothbard believes we can look back and call it irrational because magic can't achieve the ends it is supposed to achieve. "The use of magic is therefore irrational, whether in the past, present, or future," writes Rothbard.

Well sure, but Mises's point was that those folks were acting on the best information they had at the time (with considerably less brain power to work with than Rothbard).

Shermer pits Wall Street's Gordon Gecko character and his "greed is good" speech with Enron's tough aggressive corporate culture against Sergey Brin and Larry Page's Google culture of "Don't be Evil" to make his case that greed cannot sustain life on earth and "if market capitalism was winner-take-all, it would have collapsed centuries ago." Good apples turn to bad ones in secretive, corrupt, aggressive corporate environments, according Shermer, and this ultimately leads to the unraveling of those businesses.

Meanwhile the Google guys believe in complete transparency. The company has chefs on staff cooking meals so Google employees don't want to ever leave work. The work campus features games and other recreation. Employees can even get a haircut or a massage at Googleplex, and the ride home to the Bay Area on the Google bus is made productive with wireless internet access. Brin and Page believe their reputation is their most important asset and that "trust is the foundation upon which our success and prosperity rest, and it must be re-earned every day, in every way, by every one of us."

An unfettered free market would lead to more entrepreneurs operating the Google way. It is government licensing and regulation that leads to the incestuous relationship of big business and big government — a crony capitalism exemplified by Enron and Wall Street.

Shermer places too much faith in democracy and writes that science should be used to provide structure for government policies but that these laws should be minimal. Nevertheless, Shermer does write from a libertarian position throughout the book, mentioning the Austrian School specifically and quoting Ludwig von Mises often, as well as Hayek and Bastiat. And while he doesn't believe capitalism needs "apologists and propagandists, it does need a scientific foundation grounded in psychology and evolution."

Science has proved that humans are capable of good and evil. So, as Shermer quotes Mises, "People must fight for something that they want to achieve, not simply reject an evil, however bad it may be." Shermer calls The Mind of the Market "an exercise in consciousness-raising for freedom."

Eminent mainstream economists like Eugene Fama explain away stock-market bubbles and crashes with dismissive quips such as "I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning." But Shermer's work shows that science is on the side of Mises, who wrote that even a "mentally troubled person with whom there is still left a trace of reason and who has not been literally reduced to the mental level of an animal, is still an acting being." And these troubled, acting beings are investing in the market every day.

Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply. He received his masters degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee. See his tribute to Murray Rothbard. Send him mail. See Doug French's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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