Let’s Rationalize, Part 1: A mumble jumble note on irrelevant thoughts!

Rationality is an overloaded term in today’s context. Every profession uses (abuses) this word to its fullest potential. It has become a synonym to cultured criticism. It seems more cultured to say “Cant you think more rationally?” than to say “That was a foolish thought!” Let’s use rationality on two fronts, finance and microeconomics and clutter it with relevant and irrelevant thoughts.

The world of finance is divided in two prominent schools of thought, “the markets are efficient guys” like E. Fama, and the “Markets are inefficient guys”. The boundary between these worlds is getting thicker though, with more people believing that markets are very weird creatures that behave in varying degrees of efficiency and inefficiency depending on many other factors including the most prominent one i.e. insider information. Some would call it asymmetric information to make it look more rational! A rational progression of this asymmetric information is insider trading. When I first got introduced to equity markets it was tough for me to believe the dependence of this market on the regulators of the market. It took me back to my days as a child when the degree of punishment at the end of every action resulted in me deciding whether I should or should not do the action. A very rational way of making decisions as a child. Long back I had read a book that describes every individual in varying degrees of child, youth and parent. I am sure that traders have a lot of child element preserved in them. This makes me think children will make the best traders as a logical extension to the previous sentence. Professor Fama needs to address the whole foundation of modern day financial markets that are driven by payoff calculations of obeying the regulations or not obeying them. Dr. Fama needs to help these grown up children of financial markets grow into rational adults, through an alternate market structure, where insider information becomes irrelevant and not a source of arbitrage creation. Dr Fama can wrap his Market Efficiency theory on this new structure and nobody can prevent him from winning the next Nobel Prize (I am not saying that he will not get one for his current theory though. He and Jagdeesh Bhagwati are due for a Nobel; I have no idea about this, I just read this somewhere.). Let me ask you this, how rational are we in putting a rational structure over an irrational foundation.

Looks like the notion of market efficiency is also loosely (additional information might lead to say more tightly) connected to the arbitrage (I love this word and its abuse or use to make cheating look rational. In a real life situation, an Enron trader, during the California energy crisis, calls his boss and makes a comment that they were f***ing California and making a lot of money, the boss responds to make it look more professional, and the f-word was replaced by Arbitrage Opportunity) opportunity. If the markets were perfectly efficient hedge funds would not find a place in financial markets. Hedging as a word has a positive connotation, but when I was first exposed to the hedge fund strategies to create arbitrage it was difficult to find any positive trait. It seemed another example of rationalization of human greed. Don’t get me wrong I am not against Gordon Gekko (greed is good guy) nor am I against Al Gore or sustainability, but am more inclined toward rationalizing(in an overloaded sense) these two extremes of the greed spectrum. That makes me wonder are rationality and convenience (with a negative connotation) getting aligned in a modern sense. Convenience needs a lot of overlap and ambiguity, while rationalization plays a role in creating that ambiguity or in justifying it. Other word that also connects these two in modern business world is flexibility. My favorite use in business world is “Headcount Rationalization” being universally used for layoffs. Off shoring becomes some kind of operational rationalization and so on. I will continue in next part more with Rationalization and the Game theor with special emphasis on Prisoners Dilemma.