Rational expectations is a basic economic theory that emerged from a paper written by future Nobel Prize winning economist Robert Lucas in 1972. Rational expectations theory has been discussed by economists endlessly since then.
“Rational expectations theory suggests that people are aware of and act on available information, making more or less accurate forecasts,” Horwich, Minneapolis Fed, 2022.
Economists have gone down many related rabbit holes with names such as; rational bubbles, biased expectations, adaptive expectations, diagnostic expectations, price expectations, price extrapolation, learning from prices, momentum trading, and others.
On the other side of Lucas’s rational expectations hypothesis is the “irrational exuberance” of another Nobel Prize-winning economist, Robert Shiller. Shiller’s analysis emphasized that fear and fashion are in markets, and they are often irrational.
A key aspect of both rational expectations and behavioral economics is “information” and how the market responds to it. Does the market effectively analyze all available information, or is the market prone to misunderstanding information that can lead to irrational booms and busts?
Back to earth, in the case of the housing market, I got a front seat to the real estate boom and bust of the 2000s in one of the softest markets, Phoenix, Arizona.
At that time I was in favor of the idea that markets are rational but I thought that prices were moving irrationally only because players did not know enough about what was really going on in the market. The problem, I think, is that people didn’t have enough up-to-date data to make rational decisions. They were making the wrong guess about what was really happening in the market.
What we knew about the housing market at that time was a fraction of what we know today. We would get 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 didn’t start publishing official individual home sale prices online until 2005.
Today, we have much more real estate information than last cycle. Official sale prices of homes all over the internet are usually with tons of additional information and often lots of photos.
Has all the knowledge we have had in recent years about the real estate market made the market more rational as I thought it would be?
Prices rose faster this time around. We saw eight months in 2021 and 2022 when home prices nationally increased by more than any month during the 2005 boom, according to the S&P CoreLogic Case-Shiller Home Price Index.
Now, prices are also falling faster. House prices peaked nationally in June but we’ve already had two months where house prices fell by 1% or more in one month! The last time we didn’t see prices drop that much in a single month was November 2007, which was 2 1/2 years after the March 2005 peak.
It seems the explosion of real estate information online has made the real estate market less rational. Sure, it seems to have made house prices even lower.
Did all that knowledge foster some of the human quirks that the behavioral economists talked about? Can more information make irrational listening more irrational? When you can see in detail what everyone else is doing in real time, does that foster herd behavior? Apparently, yes.
In addition, the real estate market changed direction much faster this time. A lot of that was probably due to all the information available on the internet. People were not guessing like last time whether prices were falling or not. They could see it everywhere for themselves online.
Information Changes Markets
In 2005, I thought that people and markets were inherently rational and that if we knew more about what was really happening in the market, the market would act more rationally, more predictably, without the wild booms and busts all. Lack of knowledge is the problem, I thought.
However, more information seems to induce some of the human economic “irrationalities” that behavioral economists keep talking about.
Today, I’m thinking that markets are as rational and irrational as people in general. People make mistakes and sometimes markets make mistakes too because they are only human.
Maybe I was irrational 20 years ago when I thought markets were rational and the problem was a lack of information.