The Goldenbar Report

Nobel Exuberance
30 September 2003

Monthly Economics and Financial Commentary
by Ed Bugos

"Human action is necessarily always rational. The term “rational action” is therefore pleonastic and must be rejected as such. When applied to the ultimate ends of action, the terms rational and irrational are inappropriate and meaning-less. The ultimate end of action is always the satisfaction of some desires of the acting man. Since nobody is in a position to substitute his own value judgments for those of the acting individual, it is vain to pass judgment on other people’s aims and volitions. No man is qualified to declare what would make another man happier or less discontented. The critic either tells us what he believes he would aim at if he were in the place of his fellow; or, in dictatorial arrogance blithely disposing of his fellow’s will and aspirations, declares what condition of this other man would better suit himself, the critic." - Ludwig von Mises; Human Action (4th edition), pp 19; on Rationality and Irrationality; Subjectivism and Objectivity of Praxeological Research (part 1, chapter 4)

Comment by Bugos: it is this principle that has been challenged by last year's Nobel Prize winners in Economic Sciences, and thus contemporary academia.

Here we are, on the eve of what could be the most decisive primary break out in gold yet, and the bears are still kicking around old tires. Oh where's the deflation? How come the war premium has deflated and gold prices are still making new highs?

Let's bring you back a little shall we.

December 2000: Gold trades towards $260 low - bears call for $180 gold; Prechter says next $100 could go either way, but leans on bearish view. Bulls give it to him, and gold prices reverse a downtrend.

August 2001: Gold bounces around $270, just above the 200-day moving average and wants to trade up - bears say gold's rise is fool's gold; Cheryl Strauss Einhorn (Barron's writer) says gold move is temporary in an article titled "Fool's Gold."

Gold prices broke out shortly afterwards, and went to new highs.

June 2002: Gold trades up to $330ish; Barclays says it's a bubble, and tells clients to buy the homebuilders instead. They were right for a month.

August 2002: Gold trades back up to $320 area and bumps up against the old 1999 high (key reversal area) once more. The bears call it a double top, and immediately call for a $100 plunge. Forbes writer Mark Lewis titles his overtly bearish article Fool's Gold, in Strauss Einhorn's tradition. We nailed them both for it, shortly after the date of their articles.

But we didn't have to, the market did it for us. Gold prices went to new highs shortly thereafter.

January 2003: Gold spikes up to $390 in two months, finally putting in its first bullish primary sequence in two decades - bears say it's only temporary, owing to a war premium. They were right for two months. But it turned out that the correction was temporary.

By April 2003, the climax of war anxiety dissipated, and gold recovered, steadily.

The bears said it is going to be a double top, citing bearish COT reports. But the commercials have been increasingly short and wrong all along.

Meanwhile, gold shares exploded and broke out of 1 year consolidation this summer. They tend to lead bullion. And now bullion prices are at new seven year highs.

The bulls on the other hand say we're about to signal a major primary bull market in the precious metals. And they've been right as rain for three years so far!

Are the bulls going to be right again?

Well, we don't know anything for sure really. But we're still waiting for Prechter to get bullish before we agree with the bears. Don't take it too personally Bob, it's not like we don't like you. Just get off the deflation bandwagon already. The only way you'll have deflation is if the powers at be deliberate it.

Irrational Exuberance is an Oxymoron in the Field of Economics
Is buying tech stocks at 300 times earnings rational?

Is stealing from thy neighbor rational, particularly if the punishment is severe?

Is buying tulip bulbs for the price of a house rational?

Is it rational to dance around a fire and sing prayers in the hope of calling rain?

Is it rational to kill, mame, and drive a nation to war?

Was Hitler's choice to start a holocaust rational?

Is it rational to drive across a big town to save $5 on a $15 pair of underwear?

The answer is unequivocally yes, in every case. The choice of means may be faulty, and the ends may be downright mad. But in every case, the decision-maker is certainly weighing various costs and benefits, thus making value judgments and choices about which means are best to achieve certain ends, whatever they may be, and under whatever uncertainty there always is.

To that end all human action is indeed rational.

Economic activity consists of individual actions, not mere thoughts, incentives, or by what goes on in the subconscious. Expressing a thought, however, could be an action. Even not doing anything in a particular set of circumstances is considered an action in economics because it involves a choice, and has an impact.

Only actions impact on the economy, and hence only actions are relevant to the field of economics. What drives or causes those actions can at this point in time only be hypothesized, and so that's where Mises drew the line between economics and psychology.

Whether a particular end is moral or not is outside of the realm of economics. Whether a particular end is suited to the critic's idea of what is reasonable from his point of view is irrelevant to the field of economics. Economics is the science of means, not ends, Mises long ago established.

There is nothing irrational about the markets unless one forgets to ground their views in individual's actions, or unless they think they know better than anyone else.

More than 100 years ago economic science took a wrong turn; it ignored the doctrine of sound money in favor of progressive era (big government and central banking) policies. It did it again in the early part of the 20th century when Ludwig von Mises' treatise on the economic theory of money was translated into English.

Today, it is taking yet another wrong turn, as Frank Shostak pointed out about last year's Nobel Prize winners: Daniel Kahneman and Vernon Smith, in his article Behavioral, Experimental, and Austrian Economics. And thus, Ludwig von Mises' attempt to keep psychology separate from economics was betrayed, by Hayek (the only Austrian to ever win a Nobel Prize) in fact.

On this Rothbard wrote:

"This emphasis on human reason and will, in the noblest traditions of rationalism, contrast sharply to the Hayekian or Scottish Enlightenment emphasis on society or the market as the product of some sort of tropism or instinct, e.g. Hayek’s emphasis on the tropistic, unwilled emergence of “spontaneous order,” or Adam Smith’s conjuring up of a spurious instinct, or “propensity to truck and barter,” as an explanation of exchange."

"Indeed, seizing the occasion of writing a foreword to a reprint of Socialism published years after Mises’s death, F.A. Hayek significantly altered the unalloyed praise of the book that he had lavished at a tribute dinner to Mises over twenty years earlier. Now he severely criticized Mises’s reference in Socialism to “social cooperation [in particular, the market-economy] as an emanation of rationally recognized utility,” as an example of “extreme rationalism” and as factually incorrect. He went on to the insulting “explanation” that Mises had not been able to “escape from” such rationalism “as a child of his time”— a curious statement since Mises’s “time” was one of pervasive irrationalism. Hayek, in contrast, strongly asserts that “it certainly was not rational insight into its general benefits that led to the spreading of the market economy.” - Mises' Biography by Murray Rothbard - Ludwig von Mises: Scholar, Creator, Hero online edition 2002; pp32.

Mr. Kahneman is a pioneer in the field of behavioral economics. He seems to assume every individual is the same:

"People have a lot of difficulty figuring out they are just like everybody else, and what they see, everybody else can see. And making allowances for the fact that you're one of many people looking at the same time" (from a 2002 interview with AP).

Vernon Smith (Nobel prize winner 2002 - for conjuring up a lab to test real world economic theories) openly criticizes Mises for not giving enough consideration to emotions and irrational wants in human action.

But Smith precisely misses the point; that economics is not concerned with determining ends as reasonable, but only that the action which results is made with the incentive to improve the decision maker's conditions or increase his satisfaction, and the means he chooses is always made by weighing alternatives.

Ludwig von Mises showed that all human action is purposeful, with meaning... as opposed to the unconscious reaction of cells in the body to stimuli, or of an animal to food. While scientists like Smith and Kahneman prefer to reduce humans to simple organisms or abstract mathematical formulae, von Mises showed humans were more.

The idea that human action is anything but rational is absurd. It's what distinguishes us from beasts in the first place.

What's more, Mises did consider emotions:

"He who acts under an emotional impulse also acts. What distinguishes an emotional action from other actions is the valuation of input and output. Emotions disarrange valuations. Inflamed with passion, man sees the goal as more desirable and the price he has to pay for it as less burdensome than he would in cool deliberation. Men have never doubted that even in the state of emotion means and ends are pondered and that it is possible to influence the outcome of this deliberation by rendering more costly the yielding to the passionate impulse. To punish criminal offenses committed in a state of emotional excitement or intoxi-cation more mildly than other offenses is tantamount to encouraging such excesses. The threat of severe retaliation does not fail to deter even people driven by seemingly irresistible passion." - Human Action PP 16

He just wasn't concerned with the rationality of the emotion, only of the choices over the possible course of action. Moreover,

"Many champions of the instinct school are convinced that they have proved that action is not determined by reason, but stems from the profound depths of innate forces, impulses, instincts, and dispositions which are not open to any rational elucidation. They are certain they have succeeded in exposing the shallowness of rationalism and disparage economics as "a tissue of false conclusions drawn from false psychological assumptions." Yet rationalism, praxeology, and economics do not deal with the ultimate springs and goals of action, but with the means applied for the attainment of an end sought. However unfathomable the depths may be from which an impulse or instinct emerges, the means which man chooses for its satisfaction are determined by a rational consideration of expense and success." - HA, PP 16

We hardly need to add anything to that. But we will.

In the above passage Mises is saying that it doesn't matter whether the action is born of instinct, emotion, or some other deep seated unconscious factor. What matters to the field of rationalism or economics is that the course of action chosen, however unfathomable to other people, is arrived at rationally.

It may seem nonsensical to expect the stock market to rise each and every year from here to eternity, but if that is what is thought, the means that are chosen to exploit that end are determined reasonably. Even if they are wrong headed, they are ground in reason within the scope of the individual's imperfect knowledge about events.

If the investor thought the Dow was going to go to 35000, buying stocks at Dow 10000 is rational. But it may very well be ground in an incorrect interpretation of the state of affairs. All people are rational in their actions within the sphere of their knowledge of events, facts, and understanding. They do the best with what they have.

It only looks like irrational exuberance to those of us who think we know better.

But what of self-destructive behavior? Is everything humans do aimed at achieving more satisfactory conditions for themselves? I'd say so. But if someone subconsciously is out to punish themselves, they're still making decisions as to the best actions to take.

At any rate, it's doubtful everyone else sees what we all see, as Kahneman says, and certainly individuals don't all possess equal knowledge. Hence, even if they do see the same things, it is impossible for equal interpretations.

Don't believe me? Get 20 technical analysts in a room and show them the same graph.

Moreover, there is always a degree of uncertainty. But it is wrong to assume that economic decisions aren't made by weighing the available choices just because there is uncertainty.

All choice involves reason, particularly in man's case because the faculties exist so.

Economics does not attempt to classify the goals of human action as good or bad, or logical or irrational. It is simply concerned with choices involving goods and services that are scarce; forgoing one thing in favor of another in order to acquire something that makes one happier, or increase satisfaction, period.

Nonetheless, according to my dictionary, reason is an "intellectual faculty by which conclusions are drawn from premises; sense, sensible conduct." The word irrational is defined as "unreasonable, illogical; not endowed with reason."

You can probably tell that this definition doesn't quite mesh with the theory of human action that Mises established. Indeed, it is slightly different. While there is no question Mises would concede that the word irrational is valid, it is important to understand that with regard to human action it doesn't exist.

But that's precisely the point that his critics failed to grasp.

In trying to separate economic theory from the field of psychology, and build a solid foundation for the former, Mises identified a methodological dualism.

Simply put, he separated the causes of human action from the subjective laws of reason governing it. He did this by recognizing that the world does not yet have the knowledge to determine the definitive causes of any human action, and that therefore, human action is itself the "ultimate given;" the starting point for economics.

It is self evident that human action exists, and that it is always rational relative to the desired end - involving choices about how to best achieve the end.

Thus the definition of the term offered by my pocket oxford is meaningless because it suggests making a judgment that is impossible to make for anyone but one self. To know whether someone else's actions are sensible, one would have to know all of the factors in that person's interest; all their desires; all their emotions; all of their fears.

According to Frank Shostak's rejoinder in "Behavioral, Experimental, and Austrian Economics (see link above):

"Psychology was smuggled into economics on the ground that human action and psychology are inter-related disciplines. However, there is a distinct difference between economics and psychology. Psychology deals with the content of ends and values. Economics, however, starts with the premise that people are pursuing purposeful conduct. It doesn’t deal with the particular content of various ends. According to Rothbard, A man's ends may be "egoistic" or "altruistic", "refined" or "vulgar". They may emphasize the enjoyment of "material goods" and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.[8] Whereas, Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or what ends should men value?[9] Therefore, economics deals with any given end and with the formal implications of the fact that men have ends and utilise means to attain these ends. Consequently, economics is a separate discipline from psychology. By introducing psychology into economics one obliterates the generality of the theory, and renders it useless. This is precisely what Daniel Kahneman, the recipient of this year's Nobel in economics, and his followers are doing" - F. Shostak; Behavioral, Experimental, and Austrian Economics, 29 Oct 03

Mises made a point of crediting the psychology profession precisely for proving that even the most absurd desires are rooted in some kind of meaning for the individual, personally. But he also said, that it is for that reason that a line needs to be drawn between psychology and praxeology (the study of human action as regards exchange):

"The term “unconscious” as used by praxeology and the terms “subcon-scious” and “unconscious” as applied by psychoanalysis belong to two different systems of thought and research. Praxeology no less than other branches of knowledge owes much to psychoanalysis. The more necessary is it then to become aware of the line which separates praxeology from psychoanalysis." - HA, PP 12

So what can we make of the challenge to Mises' doctrine?

Very little in my opinion. It's another renascence, backwards in time, to the days when magic was the preferred explanation for real world events few understood.

Perhaps it's a sign of the times that people prefer abstract economic theories, created within the confines a laboratory, or by mathematical formula by scientists who criticize rationalism for not being real world, ironically. For I can't imagine anything more real world than theories ground in the reality of individual's actions, particularly since they have been among the only theories that have proven correct in forecasting market events in recent history.

The reason stock markets went far beyond reality in the past decade has nothing to do with irrational behavior. Rather, it is ground in the fact that most participants did not understand the impact of the Fed's money and credit balloon on individual's "valuation of input and output." The vast majority still don't. Certainly these Nobel laureates don't.

It only proves to us there is a strong socialist undercurrent in academia. By arguing that markets are irrational, and prone to failure, they can argue for bigger government and more regulation. As Frank Shostak put it:

"In particular Vernon Smith openly casts doubt on the notion that reason is the main faculty that navigates human actions. For him the main driving force are emotions. By casting doubt on peoples' capacity for exercising their brains the Nobel laureates may have unintentionally laid the foundations for the introduction of government controls to "protect" individuals from their own irrational behaviour"

Edmond J. Bugos