TABLE OF CONTENTS
1. Genesis of the Subprime Shock
2. Clarifying Analytical Framework
3. Assessing Rationality of Market Actors and Regulators
4. Risk, Uncertainty and Capacity to Act
The theory of rational choice is central to modern political science and is used in many other disciplines such as economics and sociology. Starting with Anthony Down’s An Economic Theory of Democracy (1957), and Mancur Olson’s The Logic of Collective Action (1965), in which authors used rational choice assumptions to explain the dilemmas of collective action and the behaviour of voters, political parties and interest groups in democracies, the theory of rational choice became one of the central concepts with which to explain political and social phenomena.
The foundation for the theory of objective rationality is the assumption that every actor possesses a utility function that induces a consistent order among each alternative choice that the actor faces, and indeed, that he or she always choose the alternative with the highest utility.
Over time there have been an increasing number of collections devoted to the methods of rational choice theory. In the 1940s and 1950s Simon developed a model of bounded rationality intended as a challenge to the comprehensive rationality assumptions used in economics. Bounded rationality was warmly accepted in political science. However, most economists simply ignored the new concept and continued doing business as usual (John 1999, 298). Simon (1985) also developed what he termed a procedural model of rationality, based on the psychological process of reasoning – in particular his explanations of how people conduct incomplete searches and make tradeoffs between values (John 1999, 99-300).
More recently a number of authors have criticized the model of rational decision making from sociological and psychological points of view. Kahneman and Tversky (2000) argued that framing effects demonstrate one of the most stunning examples of irrationality. March and Olsen (1996) discussed an institutional approach to political life that emphasizes the endogenous nature and social construction of political institutions, identities, accounts, and capabilities. Neither of these accounts, however, were able to provide a comprehensive and exhausting explanation of human behaviour in disequilibrium situations.
This paper will elaborate on the nature of human decision making under conditions of uncertainty. Unlike other rational choice studies, it will not claim that the rational choice approach can explain every phenomenon, but rather that the method`s explanation depends on structural constraints, within which individual choices are made. In the end, this merger of the rational and institutionalist approaches in one complex model is should present a fundamental strength in explaining complex interdependence of human actions.
The paper is based on assumption that even the concept of bounded rationality does not allow to capture the whole role of unreason in human affairs, and thus to explain it one needs to look at the environment (formal constraints and information).
I do not deny the fact that human behaviour is subject to random errors. However, it is assumed that people’s intentions to behave rationally (i.e. consistent and adequately responsive to the reality) may fail due to imperfect institutional arrangements and incomplete information available at each particular point of time. In disequilibrium situations, reliance on intuition and emotions significantly increase. However, this does not invalidate the theory of rationality. Nor does it undermine the role of institutions (both formal and informal) in shaping human behaviour.
This study will use the case of the current financial crisis which is largely described as a challenge to our assumptions about economic behaviour and the process of rational decisionmaking.
It will argue that rational institutionalist arguments may be usefully applied to understand human behaviour and decision making leading up to the current financial crisis. From this perspective, financial regulators failed to come up with efficient rules of the game in view of increasing uncertainty induced by constantly changing financial markets (informal institutional redesign); market actors, on the other hand, were completely rational in a sense that their actions were motivated by the idea of profit maximization.
The ultimate purpose of this paper is to examine what implications this case suggests for theory and policy, with particular attention to markets and government.
1. Genesis of the Subprime Shock
In a language of rational choice theory, financial crises are disequilibrium situations, or discontinuous events characterized by risk, uncertainty and the lack of balance between competing influences. At first they appear confusing as their damage stems from unrecognizable sources such as complicated financial institutions (numerous examples include programtrading during the 1987 stock market crash; junk corporate bonds in the savings and loan debacle in the early 1990s; the Thai baht and Russian bonds in the late 1990s; the technologystock bust at the turn of the millennium, etc.). However, over time their impact becomes more visible as market actors and state regulators become less capable to solve complex social problems.
The current financial crisis is described as the result of a speculative bubble in the housing market that began to develop in the United States in 2006 and has recently caused negative consequences across many other countries (Schiller 2008). It first emerged as a result of the so called “disaster myopia” in subprime lending manifested itself in weakened underwriting standards, aggressive lenders’ profitseeking behaviour and investors’ reluctance to fully assess the content of securities packages (World Bank 2008, 3-4). Numerous examples suggest that mortgage operators made only minimal efforts to assess borrower`s ability to repay their loans – often failing to verify borrowers’ income with the Internal Revenue Service, even if they were entitled to do so (Shiller 2008, 1-10). Ten years of ballooning property prices made it profitable to build homes. However, later on, when subprime defaults initiated reevaluation of the subprime mortgages, house prices went down, and the world’s credit markets locked up.
The genesis of the subprime financial shock was particularly interesting and puzzling. First of all, nearly all participants of the housing market, i.e. aggressive mortgage lenders, investors, appraisers and borrowers seemed to be suspiciously optimistic about the future of the housing bubble. Second, the role of the Federal Reserve and other regulating agencies remained quite obscure during the course of events. According to the official Federal Reserve documentation, its basic functions include (a) overseeing the nation`s monetary policy; (b) maintaining the stability of the financial system; (c) providing financial services to depository institutions, and finally, (d) supervising and regulating banking institutions to ensure safety and soundness of the nation’ s banking and financial system, including protection from bubbles. The latter function was obviously neglected despite the fact that much evidence has been accumulated about the risky lending practices.
All explanations of the current subprime crisis may be grouped into two categories: the purely psychological ones that link choices to actual cognitive abilities of people, and the empirically rich economic ones that look at the rapidly evolving global economic system.
The predominant view of the ongoing financial crisis has been the irrationality of the so called bubble thinking process . For example, trying to explain why people engage in activities which are too risky and vague, Daniel Kahneman pointed out at an obvious psychological problem stemming from a mismatch at the level of expectations in our cognitive and calculative systems (Kahneman 2009). Nazim Taleb stressed that the formation of our beliefs is even today “fraught with superstitions” and thus most decisions turn out to be simply miscalculated (Taleb 2001, 2007, 2009). Finally, to describe a heightened state of speculative fever Robert Schiller referred to the so called “irrational exuberance”, the phrase that has numerous connotations with basic problems in human psychology. In one of his books he argues that human psychology drives economies much more than is generally recognized: “Most of the movements in the stock market have a social psychological origin, and so the housing market has also become very speculative” (Shiller 2008).
Based on these arguments, will it be reasonable to suggest that empirical evidence undermines our basic assumptions about human rationality? Quite the opposite, numerous examples confirm that when several distinct episodes of nearmeltdown in markets have occurred in August 2007, March 2008, September-October 2008, a wide range of policy actions have been proposed by various governmental agencies and individual actors (World Bank 2008). Attention of governmental authorities has been shifting among several targets – commercial banks, nonbank Wall Street firms, large investment banks and subprime borrowers. However, given fluidity of evolving financial instruments, the case was resistant to various policy cures. Thus it can be suggested that the main factor behind the subprime mortgage shock was its complexity – the fact that the vast number of players (financial institutions, households, regulators) with diverse interests and preferences have been pulled into the path of this crisis, even before the extent of the damage has become clear.
2. Clarifying Analytical Framework
The main problem for most models of decisionmaking process is that they tend to give only abstract and generalized conclusions about how to explain nonequilibrium situations. Recent analyses of the current subprime crisis suffer from similar problems while tending to explain everything via such broad concepts as irrationality and random mistakes. Irrationality and random mistakes are treated as “those powerful psychological forces that are imperilling the wealth of nations today” (Akerlof, Shiller, etc.). However, one has to look at both rational and irrational components of behaviour to understand human reaction to disruptive situations. Seemingly irrational behaviour may originate in imperfect information or the lack of knowledge about particular subject area; at the same time, rational responses to the environment may be simply hidden from the observer’s perspective. As George Tsebelis argued, the problem with the observer may be that he focuses attention on only one game, and fails to grasp the logic of the whole network of nested games. A whole network of ‘nested games’ that the actor is involved in includes games in the principle arena and the so called institutional design. Both kinds of games leave space for suboptimal (seemingly irrational) choices (Tsebelis 1991).
To understand whether any actor’s decisions are rational or not one would need to assess his/her beliefs in terms of coherency and correspondence with the reality. To remind, weak requirements of rationality assure that preferences and beliefs are coherent. Strong requirements of rationality presuppose external validity, i.e. the correspondence of beliefs with reality (Tsebelis 1991, 24-28). Elester argued that rational choice explanation goes beyond mere intentionality. First, of all, we must insist that behaviour, to be rational, must stem from desires and beliefs that are themselves in some sense rational. Secondly, we must require a somewhat more stringent relation between the beliefs and desires on the one hand and the action on the other (Elster 1986, 62).
One might want to demand more rationality of the beliefs and desires than mere consistency. In particular, one might require that the beliefs be in some sense substantively well grounded, i.e. inductively justified by the available evidence. This, to be sure, is a highly problematic notion; yet here I assume throughout that it is a meaningful one (Elster 1986, 63).
The example of the current financial crisis is controversial as it situates major participants of the housing market in a constantly changing environment confronted with multiple optima and imperfect information. In this environment, institutions are well defined; however, actors turn out to be seemingly irrational in matching their perceptions to the reality (strong requirements of rationality are systemically violated). Various governmental agencies seem to systemically avoid any discussion of risks associated with the housing boom; aggressive mortgage operators are trying to maximize their shortterm gains; and individual borrowers passively follow advice given by aggressive market operators. Overall, the common factor among all participants of the housing bubble is a lack of critical assessment of all available information and the belief that the trend will continue (the so called bubble thinking process).
To understand motivations of market actors and governmental agencies one would need to take into consideration several important factors. First and foremost, all participants of the housing market have highly diverging interests and goals, and thus what is rational for aggressive lenders may be completely irrational for the Federal Reserve or any other regulating agency. Market actors, for example, tend to maximize their profits and protect shareholders from risks while governments attempt to realize public interest. Deborah Stone asserts that in the market model, individuals act only to maximize their own selfinterest however they define it for themselves. By contrast, the model intending to capture the essence of political life would have to incorporate such notions as collective goods, public interest and mutual aid. “There is virtually never full agreement on public interest, yet we need to make it a defining characteristic of the polis because so much of politics is people fighting over what the public interest is and trying to realize their own definitions of it” (Stone 1997, 21).
Second, to understand the subprime mortgage shock, one has to consider an interplay between rational actors and institutional structures (rules of the game). March and Olsen argued that behaviour is primarily rulegoverned rather than consequencegoverned and that a logic of appropriateness is the way to theorize about human behaviour (March and Olsen 1996, 162). Game theory, as Ostrom argued, in extensive form reconciles a logic of consequentiality to choices within constraints defined by the rules of the game (Ostrom 1996). In the game theory, the players face a series of options and choose one strategy that is most suitable at the time. According to the rational institutionalist perspective, the rules of the game (i.e. institutional structures) determine strategies. Each player has to make a choice that would be optimal for everybody and that would maximize each other’s payoffs. Given the fact that the rules and payoffs are fixed, it would be reasonable to suggest that the behaviour of political actors is predetermined. However, according to the game theoretic model, the situation becomes increasingly complicated as long as the actor becomes involved in a set of interrelated games. Thus the actor has chance to innovate increasing the number of available options, and the ultimate outcome (either optimal or suboptimal) depends on both the tactical and strategic considerations of multiple players (Tsebelis 1991).
From this perspective, the subprime mortgage shock may be described as a twolevel game that incorporates broad rules of the game and a set of suboptimal choices that all participants of the housing market have to make. The choices taken significantly depend on the quality of information available at each particular point of time. However, each actor makes decisions according to the rules, or what he or she considers being appropriate in a specific setting.
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