Rational inattention leads to irrational expectations

A recent Economic Letter from the Dallas Federal Reserve Bank (Vol. 6, No. 3, March 2011), written by Antonella Tutino, provides an alternative way of looking at gridlock in Congress and voting patterns in the U.S.

The Letter, “Rational Inattention Guides Overloaded Brains, Helps Economists Understand Market Behavior,” states that understanding how individuals perceive the economy is instrumental to policymakers’ efforts to achieve output and price stabilization. Rational inattention seems to be the inverse of rational expectations; the more rational inattention a consumer exhibits the less rational the expectations they demonstrate.

Today, people are awash with information, most of it accessible at near-zero cost through the Internet.  But our brains are finite biological organisms; they simply cannot adequately process all the information available.  The major purpose of higher education is to teach students how to think.  Universities provide a solid foundation of theory leading to the bottom rung of the ladder in a profession.  The progressively more competent young professional applies this theory to real world problems by thinking. Without that foundation and thinking, irrational decision-making usually results.

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When I was teaching, I used to tell our economics majors that the foundation that we were presenting would put them at a competitive advantage in the real world.  The process of understanding how the economy operates and how to operate profitably within it is not acquired by osmosis or by reading the newspaper or surfing the Web.  Economic and monetary actions and policies create impacts; if economic actors and policymakers do not think about and understand these impacts, irrational decision-making is the result.

Rational inattention can also explain the speed with which the Great Recession occurred, i.e., sharp contraction and slow expansion. Rational expectations assume that people can fully and quickly process all freely available information. But attention is a scarce resource and must be used wisely.

I also used to tell all my students, not just the economics majors, that time was the most valuable of resources.  Once it is lost, it cannot be reacquired, no matter how much money you throw at it.  It can be borrowed but one must not default on that debt.

The students in my principles of economics classes didn’t like Friday exams because partying started on Thursday night and they didn’t want to be studying.  I, of course, liked Friday exams because I could grade them and get the results back to the students on Monday. Partying was the reason for rational (?) inattention to studying.

Data shows that individuals react more quickly and strongly to loss of wealth than to an enhanced financial condition.  Thus, we will quit spending very quickly when we lose our job or it is threatened, but we will resume spending very slowly when we reacquire a job or find a more stable one.  Similarly, consumption is more easily changeable than the number of hours worked.  Thus, people are more likely to modify how much they save than the amount of time they work.

Rationally inattentive people make the most of available information by analyzing those bits that are most relevant to their well-being and disregarding the rest.  Thus, the public can make better voting decisions if politicians are transparent about what they do and why.  People pay attention according to their needs, thus they are more attentive when their economic condition is threatened than when economic conditions are more robust.

So, during the Great Recession and now, during the slow recovery, consumers are very attentive to economic conditions and national policymaking.  But they have limited capabilities to process the massive amount of information pushed at them.  As a result, pundits and politicians must make a quick impression with a short burst of information.  And, since most people don’t understand how the economy works, pushing negative information is more effective than a more lengthy explanation of an economic process.

We must educate our politicians to better understand the economic consequences of their policies and how to market them in a positive manner.  Voters must also expand their ability to make rational decisions by maximizing their rational attention and minimizing their rational inattention.

John W. Green is a regional economist who compiles the Northern Colorado Business Report‘s Index of Leading Economic Indicators. He can be reached at jwgreen@frii.com.