Rational expectations is a basic economic theory that originated with a paper written in 1972 by future Nobel Prize-winning economist Robert Lucas. The theory of rational expectations has been discussed by economists non-stop ever since.
“Theory of rational expectations holds that people are aware of and act upon available information, making forecasts that are more or less accurate,” 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 opposite end of Lucas’ rational expectations hypothesis is “irrational exuberance” from another Nobel Prize-winning economist, Robert Shiller. Shiller’s analysis emphasized that markets are prone to fads and fashions, and they’re often irrational.
A key element of both rational expectations and behavioral economics is “information” and how the market reacts to it. Does the market analyze all available information efficiently, or is the market prone to misinterpret information which can lead to irrational booms and busts?
Information Explosion
Back to earth, in the case of the housing market, I got a front-row seat to the real estate boom and bust in the 2000s in one of the bubbliest markets, Phoenix, Arizona.
At that time I favored the idea that markets are rational but thought prices were booming irrationally only because players didn’t have enough information about what was really going on in the market. The problem, I thought, was people didn’t have enough timely data to make rational decisions. They were guessing wrong about what was actually happening in the market.
The amount of information we had about the housing market back then was a tiny fraction of the information we have today. We would get monthly updates from the local MLS but it was for the entire metro Phoenix market. They didn’t even break it down by city. Zillow didn’t start publishing the official sale prices of individual houses online until 2005.
Today, we have many times more real estate information than last cycle. The official sale prices of houses are all over the internet usually with tons of additional data and often with dozens of photos.
Did all the information we’ve had in recent years about the real estate market make the market more rational like I thought it would?
No. Prices boomed faster this time around. We saw eight months in 2021 and 2022 when house prices nationally increased more than during any month during the 2005 boom, according to the S&P CoreLogic Case-Shiller Home Price Index.
Now, prices are falling faster too. House prices nationally peaked in June but we’ve already had two months where house prices have fallen 1% or more in one month! Last time we didn’t see such a large one-month decline in prices until November 2007, which was 2 and a half years after the peak in March 2005.
It appears the explosion of online real estate information made the real estate market less rational. Certainly, it seems to have made house prices even less stable.
Did all that information feed some of the human quirks the behavioral economists talk about? Can more information make irrational exuberance more irrational? When you can see in detail what everyone else is doing in real time, does that feed herd behavior? Apparently, yes.
In addition, the real estate market changed direction a lot more quickly this time. A lot of that was likely because of all the information out there on the internet. People weren’t guessing like last time if prices were falling or not. They could see it everywhere for themselves online.
Information Changes Markets
In 2005, I thought people and markets were inherently rational and if we just had more information about what was really happening in the market, the market would act more rationally, more predictably, without all the wild booms and busts. Lack of information was the problem, I thought.
It appears, however, that more information also feeds some of the “irrational” human economic quirks that behavioral economists are always talking about.
Today, I’m thinking that markets are about as rational and irrational as people in general. People make mistakes and sometimes markets make mistakes too because they’re only human.
Perhaps, I was being irrational 20 years ago when I thought markets were rational and the problem was the lack of information.