Rational expectations is a fundamental economic theory that originated in a 1972 article written by future Nobel Prize-winning economist Robert Lucas. Rational expectations theory has been discussed by economists endlessly ever since.
“Rational expectation theory holds that people are aware of available information and act on it, making more or less accurate predictions.” Horwich, Minneapolis Fed, 2022.
Economists have navigated many related rabbit holes with names like; rational bubbles, biased expectations, adaptive expectations, diagnostic expectations, price expectations, price extrapolation, learning from prices, momentum trading and others.
Opposed to Lucas’ rational expectations hypothesis is the “irrational exuberance” of another Nobel Prize-winning economist, Robert Shiller. Shiller’s analysis pointed out that markets are subject to fads and fads, and that they are often irrational.
A key element of rational expectations and behavioral economics is “information” and how the market reacts to it. Is the market effectively analyzing all available information, or is it prone to misinterpret information, which can lead to irrational highs and lows?
Back on earth, in the case of the housing market, I saw firsthand the real estate boom and bust of the 2000s in one of the fastest growing markets, Phoenix, Arizona.
At that time, I was supportive of the idea that markets are rational, but I believed that prices exploded irrationally only because players didn’t have enough information about what was really going on in the market. . The problem, I thought, was that people didn’t have enough timely data to make rational decisions. They were wrong about what was really going on in the market.
The amount of information we had about the housing market back then was only a tiny fraction of the information we have today. We were getting monthly updates from the local MLS, but that was for the entire metro Phoenix market. They didn’t even break it down by city. Zillow only started posting official selling prices for single-family homes online in 2005.
Today we have much more real estate information than the previous cycle. Official home sale prices are all over the internet, usually with tons of extra data and often with dozens of photos.
Has all the information we have had in recent years on the real estate market made the market more rational as I thought?
No. Prices have climbed faster this time around. We saw eight months in 2021 and 2022 where house prices nationwide rose more than in any month during the 2005 boom, according to the S&P CoreLogic Case-Shiller House Price Index.
Now the prices are also falling faster. National home prices peaked in June, but we’ve already had two months where home prices fell 1% or more in a month! Last time we didn’t see such a one-month price drop until November 2007, 2.5 years after the March 2005 peak.
It seems that the explosion of real estate information online has made the real estate market less rational. Admittedly, it seems to have made real estate prices even less stable.
Has all this information fueled some of the human quirks that behavioral economists talk about? Can more information make irrational exuberance more irrational? When you can see in detail what others are doing in real time, does that feed herd behavior? Apparently yes.
In addition, the real estate market this time around changed direction much faster. This was probably largely due to all the information available on the internet. People weren’t guessing like last time whether prices were going down or not. They could see it everywhere for themselves online.
Information changes markets
Back in 2005 I thought people and markets were inherently rational and if we just had more information about what was really going on in the market the market would act more rationally, more predictably, without all the booms and wild meltdowns. Lack of information was the problem, I thought.
However, it seems that more information also fuels some of the “irrational” human economic quirks that behavioral economists always talk about.
Today, I think markets are about as rational and irrational as people in general. People make mistakes and sometimes markets also make mistakes because they are only human.
I may have been irrational 20 years ago when I thought markets were rational and the problem was lack of information.
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