Rational expectations is a basic economic theory that originated in a 1972 paper by future Nobel Prize-winning economist Robert Lucas. The theory of rational expectations has been constantly debated by economists ever since.
“Rational expectations theory suggests that people are aware of available information and act accordingly, making more or less accurate predictions.” Horwich, Minneapolis Fed, 2022.
Many have fallen down the rabbit hole associated with names like economists; rational bubbles, biased expectations, adaptive expectations, diagnostic expectations, price expectations, price extrapolation, price learning, momentum trading, etc.
On the opposite side of Lucas’s rational expectations hypothesis is the “irrational exuberance” of another Nobel laureate economist, Robert Shiller. Shiller’s analysis emphasized that markets are subject to fads and fads, and they are often irrational.
A key element of both rational expectations and behavioral economics is “information” and how the market reacts to it. Does the market efficiently analyze all available information, or does the market tend to misinterpret information that can lead to irrational booms and busts?
Information explosion
Back down to earth, in the housing market, I had a front row seat to the real estate boom and bust in Phoenix, Arizona, one of the hottest markets in the 2000s.
At the time, I supported the idea that markets were rational, but I thought that prices were going up irrationally because players didn’t really know enough about what was going on in the market. The problem, I think, is that people don’t have enough timely information to make rational decisions. They misjudged what was actually happening in the market.
The amount of information we had about the housing market back then was a fraction of what we have today. We would get monthly updates from the local MLS, but that was for the entire metro Phoenix market. They didn’t even divide by city. It wasn’t until 2005 that Zillow began publishing official sales prices of individual homes online.
Today, we have many times more information about real estate than in the past. Official sales prices for homes are usually available online with tons of additional information and often dozens of photos.
Has all the information we’ve gotten about the real estate market in recent years made the market as rational as I thought?
No. Prices rose faster this time. According to the S&P CoreLogic Case-Shiller Home Price Index, we saw eight months in 2021 and 2022 where home prices rose more than any month during the 2005 boom.
Now the prices are falling even faster. Home prices nationally peaked in June, but we’ve already had two months where home prices fell by 1% or more in one month! The last time we saw such a large monthly decline in prices was November 2007, 2 1/2 years after the March 2005 peak.
It seems that the explosion of online real estate information has made the real estate market less rational. Undoubtedly, this has further stabilized house prices.
Did all this data feed into some of the human quirks that behavioral economists talk about? Can more information make irrational exuberance more irrational? Does it feed herd behavior when you can see in detail what others are doing in real time? Apparently, yes.
In addition, the real estate market changed direction very quickly this time. It probably was, according to all the information on the internet. People did not predict whether the prices would go down like last time. They could see it anywhere online.
Data is Changing Markets
In 2005, I thought that people and markets were inherently rational, and that if we had more information about what was really going on in the market, the market would move more rationally, more predictably, without all the wild booms and busts. I think the problem is lack of information.
However, it seems that more data also feeds some of the “irrational” human economic quirks that behavioral economists always talk about.
Today, I think markets are as rational and irrational as people. People make mistakes and sometimes markets do because they are only human.
Perhaps, 20 years ago, when I thought markets were rational and that the problem was a lack of information, I was being irrational.