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Tuesday, May 05, 2009

Matthew Yglesias vs Richard Posner

“At no stage need irrationality be posited to explain what happened,” -- Posner

Yglesias comments

I’ll just note as a starting point that the whole idea that one might “posit” irrationality is a powerful glimpse at the tight grasp neoclassical economics has over the public discourse. Many economic models work by positing rationality in a world that appears to be full of irrational behavior. But the models now have such a hold on our thinking, that people who suggest that sometimes things are exactly as they seem—full of irrationality—are positing something.

Beyond that, though, it’s important to make the point that for the market to exhibit irrational behavior doesn’t require individuals to be hugely loopy or anything.

Amen I comment. And more at length I go on.

I think Posner is totally full of it. He claims, in effect, that he can write a model in which everyone is rational and which fits the data. Notably this has not been done. Rather with absolute freedom to make whatever absurd assumptions are required it is possible to reconcile any set of 3 stylized facts with rationality. The models are plainly inconsistent with reality (no one denies this).

I would like to ask the judge a simple question. How could it ever be necessary to posit irrationality if it isn't already necessary ? I have not heard an answer to this question yet.
Posner, in particular, presents a few half baked arguments. Does he have a model of bank shareholders in which they rationally reward managers for short term accounting profits ? I think not. I don't believe that there is such a model.

I actually think you have a very key insight based on your command of the technical term "loopy." The point is that there is a long gap between behavior which is rational in the sense the term is used by economists and behavior which is "hugely loopy." It is not hugely loopy to believe in corporate balance sheets and profit and loss statements. It is not fully rational either. The problem is that when arguing that there is not need to posit irrationality, Posner argues that there is no need to posit huge loopiness. However, when Posner attempted to determine the implications of rationality he always used to assume the world was in Nash equilibrium.

He also assumed that there was no room for financial innovation (a requirement for the standard result that the market outcome is Pareto efficient is that financial markets are complete).

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