When I was in business school, the professors taught us that people are rational creatures. They seek to maximize the benefit of any transaction, from buying a soda to getting married. This evolved into the efficient market theory, which says that prices, especially for stocks, bonds and commodities, must be fair and accurate because they reflect everything people know about them.

Now that I’m older, I realize this assumption is preposterous. But really, I always knew that people are not rational. And to just proclaim that prices reflect perfect information has to be a tautology. I’m not even sure what a tautology is, technically, but it’s something to do with a conclusion being embedded in the question, that the premise is “logical” but makes no sense in the real world.

If people are rational, how do you explain the NASDAQ bubble of the 1990s, or the housing bubble of the 2000s? Or, perhaps, the commodities bubble of today?

I know how to explain it. People are crazy! You gotta love ‘em, but they believe all kinds of nutty theories. They base decisions on emotions rather than facts; they only believe information that conforms to their own prejudices; they follow the herd. Some people are too stupid to pursue their own best economic interests. Some are too proud, some too lazy.

How else to explain why people pay an exorbitant price for a car, or a collectible, just to prove they can afford it? That’s not rational; that’s egotistical. Or what about people’s lack of self-control — when they order a third martini, even though they know they shouldn’t, or buy yet another pair of shoes when they have no use for them?

Yale economist Robert Shiller explains the irrationality of bubbles by comparing them to a Ponzi scheme. Some people identify a legitimate economic situation; they get in early and make money as other people bid up prices. Eventually prices outrun any economic justification — yet prices keep rising because investors see prices going up and assume they will keep going up and so they continue to jump in. When people finally realize the economics don’t support the new prices, the bubble bursts, prices plunge, and almost everyone ends up losing money. These bubble prices are not efficient. They are illusory.

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