Assumption number one of all socio economic sciences is rationality. All economic theories depend on this assumption, all models of financial behaviour are built to the expectation that the participants in the money game will behave rationally. If rational behaviour does not occur, the theories and models are rubbish – of less value and must be looked at again (rubbish).
So what is this rationality? It means that given a set of choices, people will always choose the option that gives them maximum value. So, if you have a choice between two banks to save your money in, one offering 3% and the other offering 4% returns, you will choose the one that gives you higher returns. Another example: if you have a sum of money to invest, you will invest it in a project that promises you the best returns (adjusted for risk).
Sometimes this does not work, of course. We are human beings and do not always operate in our best interests. (My coaching business is built on this assumption!) Going back to the example of the investor in a project: suppose he has two choices. One with a cousin whose family have been very kind to him and put him through school where the investment will yield 10% return. The other option is to invest in the bank at 10.5%. Both investments are for the same time period. The cousin’s business is of course more risky than the bank, but not really very much more. It is an established business and he just needs the money to refresh his machinery. The business has been giving higher profits than the 10% promised for this deal, so we are quite sure we will get the money back. What should our investor do?
Rationality demands that he maximises his returns and invest in the bank. But when unquantifiable emotions of loyalty, friendship or even fear come into the picture, economic decision making will not necessarily be rational. How will the computers and the financial models deal with this issue?
This is not the only time when rationality is abandoned. How many of us have said, “I must have a salad for lunch” and ended up eating something much more calorific? The rational decision making process was abandoned for something that gave a different kind of value. Or invested our purchasing dollars in the chocolate market when other markets made stronger calls on our wallet.
Why bother with rationality at all? Why does it matter? Because all of our markets are built and sustained on their ability to predict. The salad bar stocks as much salad as they predict rational customers will buy. If impulse takes over from rationality, then the shopkeeper must hold wasted stock, which, since it is perishable is a clear loss.
Banks too have the same principle. They hold only as much loose cash as they predict will be required by their customers on a daily basis. The rest of the money that we put with them is invested in other people’s projects – locked away for a few years – you many say. If rationality gives way to fear, there will be a run on the bank. They will need to pay out more than they predicted, which of course isn’t there, at least for now.
What does that mean for us, the ordinary joe-on-the-street? Do we hold on to rationality just to keep their precious models and big banks going? Because, I’m going to do what’s right for me.
And that’s the difference between micro and macro economics. Ditch the jargon, stay with the story. If I, blogjoe, feel insecure about my income and savings, I will start hoarding my money. Hell, I’ll even buy 50 cans of baked beans every few months and save them up. And so will a lot of people, because they are doing what’s right for them. If I could, I’d even stock up electricity payments and such like. And, I’m going to stop buying shoes, bags, chocolate, newspapers, cut back on cigarettes and alcohol.
What does that do to the economy if all of us do this? It kills the shoe industry, bag industry, chocolate industry etc. And they are employers too….but not for long. No income for them means no pay for their employees. Redundancies loom. Less money to spend means more companies in trouble, means more redundancies.
Does everybody suffer? And what does this have to do with rationality?
No, everybody does not suffer: The baked bean companies should do very well if all of us keep buying (till we get sick of them and the economy picks up!) Utilites are essentials, they should do well, as should discount retailers. Our economic behaviour is perfectly rational, from our point of view. But my rationality is not our rationality. Once we understand that, we begin to understand why we are in a recession.