Rationality of Man and Markets

In last week’s New York Times Magazine, Paul Krugman takes economic science to task. There is a ton of stuff in here that is good and crazy. But I find the discussion of market rationality to be one of the more interesting discussion points. Krugman writes:

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth…

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation. […]

But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off.

Curious, because I always thought the progressives were the Utopians. Isn’t it the progressive ideal that, through planning, careful government direction, and expert control, that the economy (or other public structure) can be made near perfect? Or at least, the progressive ideal believes that with the proper distribution of wealth and means of the production poverty can be eliminated and economic growth will be perpetual. So the progressive ideal would believe strongly in the rationality of regulators, and the ability of mathematicians to predict changes in the market. Surely it would be problematic to have knowledgeable, but potentially irrational, regulators.

Meanwhile, real classical liberalism is a more constrained view of human action. The belief in highly complex models to solve every problem in the market is not inherently a free-market idea. In fact, it is a product of progressivism (and may explain one reason why Wall Street traders seem more likely to vote democrat even when the GOP is supposedly the party of big business). Free-market theory rightly understood knows its own limitations, that there will be bumps in the market, that there will be profit and loss. But it starts by pointing out that statist control creates distortions and inefficiencies all its own. Redistribution attacks (on some level) the incentives to create, to progress. The free market is a natural structure for ordering the economy, working out inefficiencies over time and dealing with new ones flexibly as they come along.

Meanwhile Krugman, as well as Justin Fox, are carrying the torch that says this meltdown strikes at a belief in human rationality. But somehow the progressive analysis keeps ignoring the possibility that market actors were perfectly rational in their choices, just misguided and led by bad incentives (many government created). I think both traditions (and their variations) should acknowledge the rationality of man, but understand its relative place to incentives. A rational man can easily conclude a choice of activity that is ultimately harmful to him given inadequacy of education or disincentives.

Happy Labor Day!