24 August 2015

Economists need to entertain the human element


It is holiday season. It is the time of the year when we have the chance to sit back and think about the bigger picture. It is the time of the year when we get a rest from the minutiae of daily life. It is time to feel human again.

If you are an economist, like me, you might find yourself reflecting on one of the biggest forces to challenge the discipline in recent years: behavioural economics. Summed up in one sentence, this is the notion that the standard assumptions made by economists – that human beings are rational, self-interest and calculating – need replacing by more realistic assumptions about human behaviour. In other words, that economists, or at least the people in their models, need to become more “human”.

If you are not an economist but have spent your summer holidays, past or present, reading books such as Cass Sunstein and Richard Thaler’s Nudge or Daniel Kahneman’s Thinking, Fast and Slow (they were, after all, difficult to miss), you might find yourself wondering why economics continues to be slow to adapt to a more realistic view of the way people behave, and, dare I say it, whether this represents a failure or a strength of the discipline.

Whilst the psychological evidence has helped to reveal all of the flaws involved with being human, many economists still feel safe turning a blind eye, convinced that the divergence between the people in their models and the people in the real world is of little consequence. Embracing things like emotion might make their models more realistic, but if it doesn’t change the results, then it is just adding needless over-complication. As the Nobel Prize winning economist Milton Friedman once famously noted, if we want to formulate a model which helps us to explain the actions of a snooker player, we will arrive at the most accurate predictions if we build the model assuming that the snooker player has a good grasp of physics. A model in which we instead assumed that the player did not, which would likely be more realistic, would lead to worse – not better – predictions.

The Friedman defence is, as you might expect, very popular. At a recent seminar I attended, a senior economist responded to a paper on behavioural economics by saying that whilst human flaws might help us to understand the “little” things, they have not helped us to understand the “big” things – those that really matter for the economy. Whilst his name did not receive a mention, Friedman was ever present. His ghost haunts all such discussions. Economists’ gut intuition is, after all, that the traits captured in their models – the selfishness, rationality and cold calculation –  are those responsible for the wealth and sophistication of the modern day economy. It is also by employing such traits that economists have been able to “prove” that the market can deliver a stable outcome and that the only threat to this stability is outside interference or outside “shocks”. No wonder they want to hold on tight.

In the real world, emotions, irrationalities and fallibility certainly exist, as any economist will be happy to admit, it is just that they are not seen as being particularly relevant to understanding the economy. As far as economists are concerned, real human behavior is for our love lives and for what goes on within our homes (unless you are Gary Becker, and that’s a story for another time). It has nothing to do with either the forces that make our economy richer over the longer-run, or the forces which wreak havoc along the way in the form of the business cycle.

It is this utter faith in the power of self-interested, rational and calculating behavior to explain economic life that is central to understanding why so many economists are still resistant to a more realistic model of human behavior. It is this faith which needs to be tested and, with time on our hands in the holiday season, there is no better time to take on the challenge.

1) Economic Growth

We are all familiar with the market-driven story of rising prosperity. Markets, as we know, incentivise financially motivated and self-interested individuals to invest and invent. They create potential customers, and so a possible financial reward (the carrot), whilst the competition that they bring (the stick) ensures that firms take the necessary measures to keep costs low and to increase their productivity. Perhaps naturally, therefore, rational, calculating and self-interested behavior has come to be seen as an important driver of economic prosperity.

Receiving much less attention, however, are the other aspects of human behavior. There is the cooperation (as opposed to competition) without which markets would not have first become firmly established. There is the care and altruism we see outside of the market, something which creates the next generation of productive and well-functioning human beings for our economy to draw upon. There are also those human flaws which spur us on, despite what “rational” calculation might tell us. Or, as Keynes so neatly phrased it, “‪[i]f human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation.‎”

Indeed, as one leading economic historian, Joel Mokyr, has argued, many of the technologies and investments associated with the snowballing of invention in Europe in the Industrial Revolution would not have taken place were inventors purely driven by financially motivated self-interest. The patent system was expensive and cumbersome and few inventors actually profited from it. If it acted as encouragement, it was because of the human tendency to over-estimate our chances of success. In other words, what an economic theorist might see as “irrationality” has actually pushed us onwards and upwards, encouraging us to take uncalculated risks and to believe in ourselves.

And we should not stop there. We cannot mention economic growth without mentioning scientific research. Scientific research forms the bedrock of the technological advances taking place in the private sector. Here, we have to admit that many scientists are not incentivised by personal financial reward but by other things entirely, including the public good. The Enlightenment movement, which Mokyr holds responsible for the rise of the West, involved scientists working together for motives other than profit, including to help make the world a better place for the public at large, or, more plainly, for reasons of natural curiosity. Whilst private-sector activity might rely on profit-driven self-interested behaviour, it draws upon the ideas and innovations of scientists working with very different motives.

In sum, the developments which brought Europe and the US to the peak of their economic success were driven just as much by the human tendency to behave in a cooperative manner, to nurture, to be (at times) irrational, and to seek more than pure financial return as they were by the kinds of motives more often associated with economics. Our wealth has not been created by robots but by humankind, with all of its frailties.

2) Boom and Bust

Not only is a more realistic understanding of human psychology vital to explaining how economies progress in the longer-run, it is also essential to understanding why they are prone to boom and bust. Most traditional explanations of the business cycle revolve around the idea of “shocks”. Their assumption is that left to its own devices, and without interferences from government or from trade unions, the economy will be more or less stable. Markets should clear, ensuring that everyone who wants a job has a job and that every firm is able to sell whatever it wishes to produce. If the economy goes into “recession”, it is the result of an outside shock on either the demand or supply-side. The best way of insulating our economy from boom and bust is, therefore, to make sure that markets are flexible so that they can adjust quickly to such shocks. There is no need to regulate the availability of credit or to be concerned with the movement of the stock market, as rational self-interested and calculating behavior should ensure that no one is tempted to over-spend and that stock or property prices are not excessively bid up above their “true” values.

Keynes, by contrast, had a very different way of thinking about economic ups and downs, one in which human imperfection was central. His starting point was that we can never predict the future. This is a major stumbling block as it is, unfortunately, something we nevertheless must attempt to do when deciding whether or not to invest and how much to spend. However, with little basis on which to make such calculations, rational, self-interested and calculating behaviour of the kind economists assume can be very difficult, if not impossible. Keynes argued that, instead, we therefore rely on rules of thumb and look around at what other people are doing. As a result, it does not make sense to look at the behaviour of individuals in isolation, as is common in economic models. Instead, we have to think about social interactions. In the words of Robert Shiller: “Investing in speculative assets is a social activity. Investors spend a substantial part of their leisure time discussing investments, reading about investments, or gossiping about others’ successes or failures in investing. It is thus plausible that investors’ behavior (and hence prices of speculative assets) would be influenced by social movements.”

According to Keynes, with little in the way of “fundamentals” to help anchor economic decisions about investment and consumption, the economy will blow with the wind – with whatever people en-masse have come to ‘think’ will happen in the future. If a feeling of exuberance takes hold, the economy will go up and up until the alarm bells ring, at which point it will tumble. In other words, boom and bust must be understood in the context of our limited capacities as human beings. By assuming that we are “perfect”, economists have come to the conclusion that the economy will behave perfectly, assuming away economic reality and the challenges real people face.

3) The other ghost in the room: enterprising man versus emotional woman

The failure of mainstream economics to fully get to grips with the causes of economic growth, or to explain boom and bust, something which resulted in governments being taken by surprise when the financial crisis hit, follows from one basic wider failure of the subject: a failure to entertain anything that could possibly be considered feminine. Friedman’s ghost is not the only one that haunts economists’ seminar rooms, holding them back from entertaining a more realistic model of human behaviour. There is also another ghost: that of macho man. This is a ghost that really should be dead and buried.

By leaving real human behaviour out in the cold, economists have not only simplified the world but have sacrificed their ability to understand what goes on around them. This sacrifice originates in their belief that traits such as cool calculation and selfish behaviour are either superior to all others or inherently more useful for the economy compared with those more traditionally associated with that group of people that economics has failed to sufficiently include: women.

Rationality, calculation and imperviousness to emotions are the traits most stereotypically associated with men. Since men have historically been thought to be superior to women, stereotypically female traits are viewed with skepticism and suspicion, not to be incorporated into the perfect models being constructed by economists. The route into economics for a woman involves shedding her “femininity” and adopting the stereotypically male way of looking at the world; it is certainly not to encourage economists to embrace traits which have historically and stereotypically been associated with women, whether that be emotions or “irrational” behavior. That would be “soft” and “unrigourous”.

If you are “soft”, you are soon weeded out. Hence, the standard set of assumptions employed by economists would seem to be entirely fair. That is, until we realise that the sphere of market production is only one half of the story. The activities taking place outside of the market, which depend on care, love and altruism, are just as important for understanding economic success (and failure), and yet have been largely neglected simply because they have remained out of the view of what are mostly male economists. This neglect has come with adverse side-effects, ones which now bite our economy; taking something for granted can very easily lead to its erosion. Only by understanding that we are not robots can we fully understand what makes an economy successful or unsuccessful.

If economics is to make progress in its understanding of the economy, something which will help the rest of us and hopefully help us to avoid another major economic collapse, economists need a lesson in self-awareness. They need to tune into their inner gender biases: they need to admit that their macho way of thinking about the economy leaves much to be desired, that we have seen a movement known as feminism, that family and society matter, and that it is time to think differently about men and women.

In sum, I encourage my fellow economists to get out more, to see what has been going on in the society which surrounds them and to talk to people other than economists (including their own families). The summer holiday is the perfect opportunity.

Dr Victoria Bateman, Economic Historian and Fellow in Economics, Gonville & Caius College, Cambridge, and Fellow of the Legatum Institute, London.