Many long-time readers have met my wife Patsy. She is woman of strong character, great generosity, and an impeccable moral sense, but Economics is not her forte. Patsy recently accompanied me to a conference hosted by the Federal Reserve Bank of Atlanta and held on one of the Georgia Sea Islands. One morning over breakfast, I outlined the classical theory that economic decision-making is entirely rational. Patsy burst out laughing.
Patsy’s spontaneous reaction was spot on. There is very little that’s rational about economic decision-making, or any other kind of decision-making for that matter. In his new book, Human: The Science Behind What Makes Us Unique, cognitive neuroscientist Michael S. Gazzaniga describes patients with injuries to a part of the brain that rendered them unemotional. One patient, for instance, “tested normally in intellectual ability, social sensitivity, and moral sense, and could devise appropriate solutions and foresee consequences to hypothetical problems, but he could never make a decision.” Gazzaniga’s conclusion from this study and much additional research is that “pure reason was not enough to make a decision. Reason made the list of options, but emotion made the choice….Even though we humans like to think of ourselves as being able to make non-emotional decisions, emotions play a part in all decisions.” (pp. 72-73)
Like Patsy and Dr Gazzaniga, we all know this. We know that even our most basic economic decisions about food, shelter and clothing—the things we need to stay alive—are heavily influenced by non-rational forces. Otherwise, who would ever wear high heels? Decisions about finance and business are no different. “Jack Welch’s phrase ‘straight from the gut’ sums it up: decisions that matter for investment are intuitive rather than analytical.” (p.144)
The authors of this assertion are George A. Akerlof and Robert J. Shiller. Akerlof is a Professor of Economics at the University of California, Berkeley. He won the Nobel Prize for Economics in 2001 and is married to Janet Yellen, the former President of the Federal Reserve Bank of San Francisco. Shiller is Professor of Economics at Yale and co-creator of the influential Case-Shiller Home Price Index. Earlier this year they published Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The book’s premise is that the current economic crisis “was caused precisely by our changing confidence, temptations, envy, resentment, and illusions—and especially by changing stories about the economy.” (p. 4) The authors call these emotional forces “animal spirits” following John Maynard Keynes, the famous British economist who coined the term in the 1930s. Keynes believed that animal spirits, or “the spontaneous urge to action,” are the essential motivation behind business decisions. But while Keynes’s economic prescriptions form the heart of the global financial rescue plan, and his description of how capitalist economies function is more or less gospel, his conclusions about how decisions are made have been largely discarded.
Although purportedly written for a general audience, Shiller and Akerlof are not really focused on lay readers. Their true target is academic economists. The book is filled with what can only be called blatant rebukes to the profession. Here is just a sampling:
“Natural rate theory (the idea that there is a sustainable level of unemployment that keeps inflation in check) is now economists’ conventional wisdom. It is accepted by the vast majority of economists—but we do not believe it to be true. And it has also been the justification for economic policy of great foolishness.” (p 107)
“Over the years economists have tried to give a convincing explanation for aggregate stock price movements in terms of economic fundamentals. But no one has ever succeeded.” (p.131)
“The theories economists typically put forth about how the economy works are too simplistic.” (p.146)
“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory.” (p.167)
I could go on, but you get the point.
So why do academic economists refuse to take animal sprits into account? Why do “they fail to consider the most important dynamics underlying economic crises”? (p. 167) Shiller and Akerlof get part of the answer to these questions, but they too are part of the academy and they cannot or will not follow their conclusions to the source.
The part they get is that economists have insisted on a theory based on rational behavior because it can be quantified and modeled. “In their (that is, economists’) attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structures and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.” (p. 168) Dear reader, I will make you a deal. I know there are a lot of quotations in this commentary, but I promise not to include any more if you re-read this one slowly and carefully.
Good. Now, what Shiller and Akerlof don’t get is why economists wanted to “clean up macroeconomics and make it “more scientific.” For the answer we have to go back to 1957. In that year, the Soviet Union successfully launched Sputnik, the first artificial satellite. It was the height of the Cold War, and America was stunned. The Federal Government responded in the best American tradition: It threw massive amounts of money at universities for mathematical and scientific research so that we would not lose the Space Race. Suddenly, brand new physics and chemistry buildings sprang up on campuses across the country. Professors got grants for all the equipment and graduate students they wanted. The liberal arts had to make do with the dowdy old buildings the scientists abandoned. The message was obvious. Science equals money, power, and prestige. Economists realized that if their field became a science, a Social Science, they could cash in too.
There were two problems with this change of direction. Since the discovery of relativity and quantum mechanics in the first quarter of the 20th century, the advances in the hard sciences have required increasingly more difficult and abstruse mathematics. The math has made it all but impossible for non-scientists to follow new developments, which is why so many books and articles on physics and biology for laymen are published every year. Scientists want their discoveries understood by the widest possible audience. Altruism and a desire for recognition undoubtedly play a role in this spate of publications, but scientists know that without public support, their funding could be threatened. An informed public is clearly in their interest. Economists faced exactly the opposite situation. The father of economics, Adam Smith, did not include any calculations or statistics in his 1776 masterpiece, The Wealth of Nations. Things didn’t change much in the next two hundred years. Economics was a qualitative discipline that required no special mathematical knowledge. It was more or less accessible to any reasonably well educated person. To become a “real” science, Economics (with a capital E) had to become less accessible and more quantitative.
That led to the second problem. At some level, economists knew just as well as everyone else that economic decisions aren’t rational. But you can’t be a scientist unless you can make mathematical models, and irrationality is extremely hard to model. So economists made models using assumptions of rational behavior in hopes that they would be close enough to reality to be useful.
But they aren’t. Economists have been no better at predicting the economic future than anyone else. Oh sure, a few predicted the 1987 stock market crash, and a few predicted the long boom of the 1990s, and a few predicted the dot-com bubble, and a few predicted the spectacular rise in home values, and a few predicted the housing debacle that followed. But nobody predicted all or even most of it. And economists aren’t even very good about predicting the past; the causes of the Great Depression remain a subject of debate.
It may seem that I am specifically attacking the economics profession for short-sightedness, greed, or vanity. Not really. I have singled out economists only as an example. The heart of the matter is categorization. The 20th Century was all about putting things into categories, creating specialties, and making experts. Economics, considered as specific academic discipline is as artificial as Sputnik, and so are chemistry, Russian literature, and playing the clarinet. Perhaps no one person can be proficient enough to earn PhDs in all these fields, but that simply speaks to our limitations as human beings. The fields themselves are all parts of the human and universal condition. They are not inherently discrete, and many people have a good understanding of and keen interest in them all and more besides. Twenty-first Century communications, globalization, and the interactive Internet community are rapidly breaking down the barriers between disciplines that were so painstakingly erected in the previous century. In this century “doing the math” will only be a part, and small part of understanding economics. A full understanding will require “doing” and blending the cognitive science, the psychology, the sociology, the history, the linguistics and maybe even clarinet playing. Welcome to the Fun House.