The Story of Money: The Irrationality of Rational Action

A key thread running through all my writing in this series is how each of these topics, and how economics as a whole, relate to each of us, here and now. So let’s today tackle the question of how human behavior impacts markets and how that impacts each of us back.The key tension here, as I’ve noted before, is that economics tries to be a precise science while seeking to describe messy human reality. In this spirit, economics, or at least some branches of it, have posited that humans are rational - not in the sense that we normally understand that term, but in the sense that they behave in ‘economically optimal’ ways, given that particular branch’s definition of optimal. There is even a term for this: homo economicus.Under this line of thinking, it is said that one rationally carries out a cost/benefit analysis of every action prior to a decision. (Mind you, this needn’t be with a spreadsheet and 3 pie charts, it could be intuitively and even inexplicably.) In practical terms this is said to mean that as consumers/producers we seek to maximize utility/profit. (For a more precise and unadulterated definition of the oft-misunderstood word ‘profit’ see Episode 004.)Weighing WantsTo get to the heart of this, we have to look closer at the term value, which I introduced in the aforesaid episode, and have discussed elsewhere in this series. Specifically we have to consider perceived value, a fundamentally subjective concept.As an example, when we discussed price in Episode 003 we saw how it’s a sort of ‘negotiation’ between the buyer and seller. In the current terminology we’d say they’re each seeking to maximize their utility/profit, ie, they’re being rational. This could depend on several factors, including, for example, supply and demand which we discussed in Episode 017 but ultimately if something is subjective, how do we pin it down with precision? How do we put a number to it?Furthermore, how do we satisfactorily explain or predict such perceptions of value among individual actors in the economy? For we have also seen, as I’ve noted previously, if we can’t measure something do we even know it well enough?All this goes to the very tension of economics I was referring to.In Fool BloomSo far we have considered the question of a single entity, but let’s see how this pans out in aggregate. Imagine it’s 1600s Europe, the early age of exploration, and an exotic and rare new flower is introduced into a country. Instantly, it becomes a status symbol for the rich and everyone’s after them - the price of the flower skyrockets, so much so that at its peak, one variety of the flower is sold for several times the salary of a skilled craftsman!If you think this is contrived it’s not, this actually happened in the 1630s in the Dutch Republic, then undergoing the Dutch Golden Age - the Tulip Mania.It may be irrational, in our normal sense, for a buyer to be rational (an alcoholic seeking to buy more alcohol and thus find more ‘utility’?) but if this is scattered about among individuals here and there it’s one thing. But we can see what happens when everyone joins the bandwagon of this irrationally rational behavior, such as in the Tulip Mania mentioned.If tulips can be sold at such exorbitant prices as hinted, why would anyone be incentivized to grow wheat or other essential crop? Given that buyers are valuing, and thus paying, more for a shiny new flower than food? But how does that perceived value of the rational actor square with the real and proper value lost in the economy as a whole, and ever in the long term, by such collective irrational exuberance?So the price of the given asset-in-obsession goes up and up and up - and the more it goes up the more people think it’ll go up, and so well, ‘rationally’ they buy it up, and the more it goes up! This is what is called a bubble.But how long and how big can we go on inflating a bubble? What happens when the music stops? And that is exactly what we will explore next time: arguably the mother of all crashes in financial history!Article written by Ash StuartImages, video, voice narration and some footnotes generated by AINothing in this presentation constitutes as advice - financial, investment or otherFurther Reading & Reference* The Intelligent Investor, Benjamin Graham - read from the very “Father of value investing” This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit ashstuart.substack.com