Can Irrationality Be Rational?

There is an interesting (albeit flawed) analysis in this month’s New Yorker by John Cassidy: Rational Irrationality. The subject is “the real reason that capitalism is so crash-prone.”

The author’s main point seems to be its rational to pursue profits even in an irrational manner when everyone else is profiting from it. Indeed, to miss out on gains — even ruinous ones that force your firm into bankruptcy — is irrational.

How can we spot the flaw in that argument?

Many children have been admonished as a kid, “If all your friends jumped off the Brooklyn Bridge, would you?” Yet that excuse seems to be the basis for some of the worst, money losing decisions made by the financial sector.  All of the cool kids were doing it!


“The same logic applies to the decisions made by Wall Street C.E.O.s like Citigroup’s Charles Prince and Merrill Lynch’s Stanley O’Neal. They’ve been roundly denounced for leading their companies into the mortgage business, where they suffered heavy losses. In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them. C.E.O.s certainly don’t have much personal incentive to exercise caution. Most of them receive compensation packages loaded with stock options, which reward them for delivering extraordinary growth rather than for maintaining product quality and protecting their firm’s reputation.” (emphasis added)

Pardon me, but the easy choice of aping your competitors ruinous policies is hardly CEO leadership. Sometimes, you have to make the difficult decision, even if it costs you short term. Otherwise, this line reasoning requires one to assume that there is never any “objective reality.” It is herding writ large, only with billions of dollars leveraged up. There is never a good reason to practice risk management, to avoid aggressive speculation when your peer group is so engaged.

For example:

“This was the climate that produced business successes like New Century Financial Corporation, of Orange County, which originated $51.6 billion in subprime mortgages in 2006, making it the second-largest subprime lender in the United States, and which filed for Chapter 11 on April 2, 2007. More than forty per cent of the loans it issued were stated-income loans, also known as liar loans, which didn’t require applicants to provide documentation of their supposed earnings. Michael J. Missal, a bankruptcy-court examiner who carried out a detailed inquiry into New Century’s business, quoted a chief credit officer who said that the company had “no standard for loan quality.” Some employees queried its lax approach to lending, without effect. Senior management’s primary concern was that the loans it originated could be sold to Wall Street. As long as investors were eager to buy subprime securities, with few questions asked, expanding credit recklessly was a highly rewarding strategy.”

I disagree. Chasing short term profits regardless of cost is not “Rational Irrationality” — its short termism of the worst kind. And if it ultimately leads to your firm’s liquidation, how rational is that?  That is the equivalent, IMO, of suggesting you can set the race track record on the straight away, ignoring the hairpin turn at the end. So what if you smash into the wall! You were, for a moment, winning!

Rational Irrationality” asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong.

I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable — its NEVER rational.

Goldman Sachs avoided most of the credit debacle — were they being irrational when they forewent short term profits for a few years — but avoided the worst of the sub-prime debacle? And what about hedge fund manager John Paulson? His fund bet against all of these other players, netting several billions in profits while others suffered from their “Rational Irrationality.” How irrational was Paulson’s investment posture?

On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.


One last thing: The article also manages to get through the entire subject without so much of a mention of Hyman Minsky, the economist behind what has become the definitive theory of why Capitalism is so crash prone: Stability breeds over confidence, which breeds instability. See Stephen Mihm’s aricle, Why capitalism fails for an excellent discussion of the same. Perhaps understanding that aspect might provide the reader with greater insight than rational irrationality does . . .


See also
The synchronous lateral excitation of markets (or pseudo-wobbles)
Paul Murphy
FT Alphaville, September 29, 2009

Rational Irrationality
John Cassidy
New Yorker, OCTOBER 5, 2009

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