Living with irrationality

The following was a letter published in The Guardian this morning and I felt I had to quote it because it so closely matches my own views.

Markets are “unnerved”, “market confidence is fast deteriorating”, “market expectations [or should that read speculations?] are not met”, all of which adds up to “global markets being haunted by fear”. Where is the “rationality” in all of this, ie rational people making rational and informed decisions, which presumably is the mantra that underlies the principle and justification of “free market economy”?
Wolfgang Wittwer

Humans are conscious animals. This means we are capable of exercising reason and acting on information and cool judgement. It also means we make gut responses often based on our perceptions of what others are doing or what we think they are doing or what we think they are likely to do. It is this last bit that is crucial for getting a handle on market gyrations. This morning, for example, the FTSE 100 index has dropped some 2.5% since last night, a huge fall but following persistent weakness since the start of the new year. One year ago it was around 7000, now it is hovering at 5500. How can a rational market work in this way? Obviously it cannot. Either everyone got it wrong a year ago or they are all getting it wrong now. The current downswing may prove self-fulfilling in that it creates a climate of uncertainty that causes investment spending to fall and precipitates an economic depression. Or it may be seen, in a few months time, as a foolish over-reaction, as the industrial economy picks up under the stimulus of lower energy prices.

We cannot predict the future with sufficient accuracy and therefore all financial investments take the form of a risk based on a mixture of judgement and instinct. But judgement in this case is also heavily dependent on instinct because the future will hinge on whatever everybody else does and we can only guess at what that may be.

When people, and often they are politicians with little experience in economics, talk about the efficiency of markets and the need for market-based solutions, they betray a frightening ignorance about the way that humans think and act.

I shall probably return to this theme.