“Irrational” Exuberance Explained!

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Much has been written about the “irrationality” of the homus economicus and many renowned economists have talked about and have attempted to explain the “irrational” exuberance of the markets.

The last attempt to explain this apparent irrationality has been by Xavier Gabaix who theorizes that people have limited attention, known in psychology as “Bounded Rationality,” but bounded by what? Well, usually by time horizons, i.e., people seem short-sighted when it comes to viewing beyond economic aspects such as a slowdown or a recession some years into the future.

According to Investopedia:

Homo Economicus” is a term that describes the rational human being assumed by some economists when deriving, explaining and verifying theories and models. Homo economicus, or economic human, is the figurative human being characterized by the infinite ability to make rational decisions. Certain economic models have traditionally relied on the assumption that humans are rational and will attempt to maximize their utility for both monetary and non-monetary gains. Modern behavioural economists and neuroeconomists, however, have demonstrated that human beings are, in fact, not rational in their decision making, and argue a ‘more human’ subject (that makes somewhat predictable irrational decisions) would provide a more accurate tool for modelling human behaviour.”

I respectfully disagree, humans are indeed rational and will always attempt to maximize their utility for both monetary and non-monetary gains.

The crux of matter that creates such despair among economists, is not derived from the apparent “irrational” behavior attributed during some decision-making processes, e.g., back in 2000 when Alan Greenspan talked about the irrational exuberance of the markets — where investors were pouring money on companies that not only were not making any profits but were losing massive amounts daily — , it is derived from not defining utility properly, in other words, looking at “irrational” behavior from a purely economic or benefit/cost analysis. So, if the benefit, or utility, is greater than the cost it is only rational to do it, but if the cost is greater than the benefit or utility it would be “irrational” to do it.

But here comes the interesting part, what or how is utility defined?

Investopedia defines “Utility” as “an economic term introduced by Daniel Bernoulli referring to the total satisfaction received from consuming a good or service”.

Here is the key to solving the apparent irrationality, namely, total satisfaction. What gives me total satisfaction does not necessarily give satisfaction, let alone total satisfaction, to my brother and vice-versa.

In psychology, the level of satisfaction or dissatisfaction is directly related to positive or negative Hedonic Tone or Valence respectively. Thus, when something provides a positive hedonic tone or valence the economic benefit/cost analysis is overridden and becomes irrelevant, no matter how much greater the cost may be over the benefit.

In the same vein, when something provides a negative hedonic tone or valence the B/C analysis is also overridden, no matter how much greater the benefit may be over the cost, the B/C analysis also becomes irrelevant.

This is because total satisfaction or utility cannot be adequately measured by economic models, let alone by a simple benefit/cost analysis.

This is succinctly explained by the famous saying “somebody’s trash is somebody else’s treasure.”

Or, to put it more poetically in Balzac’s words:

Le coeur a ses raisons que la raison ignore”!

JC Wandemberg Ph.D.

President & Founder

Sustainable Systems International

About the author: Dr. Wandemberg is an international consultant and stocks trader, keynote speaker, published author, professor, and analyst of economic, environmental, social, managerial, marketing, and political issues. For the past 30 years Dr. Wandemberg has collaborated with corporations, communities, and organizations to integrate sustainability through self-transformation processes and Open Systems Design Principles, thus, catalyzing a Culture of Trust, Transparency, and Integrity.

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