The failings of economists - the bum forecasts and less-than-wise advice
they give us about the choices we face - can usually be traced back to
the limitations of the basic model that tends to dominate the way they
think, the neo-classical model.
The thinking of economists began to
ossify in the second half of the 19th century, at a time when the
science of psychology was in its infancy. The model was thus
consolidated at a time when our understanding of human behaviour was
quite primitive.
Unfortunately, the past century of progress in
psychology has revealed just how far astray are many of the economic
model's assumptions about how humans tick. Although a minority of
economists - "behavioural economists" - have sought to incorporate these
findings into their thinking, the majority have ploughed on regardless.
It keeps the maths simpler.
The model is often criticised, not
least by me, for its key assumption that we are always "rational" -
carefully calculating and self-interested - and never instinctive or
emotional in the decisions we make, but there's another assumption
that's equally unrealistic and likely to lead to wrong predictions about
how we'll behave.
It's that consumers and businesses always act
as isolated individuals in making their decisions, uninfluenced by the
decisions those around them are making, except to the extent that the
combined behaviour of others affects the prices the individual faces. In
other words, the model's "unit of analysis" is the individual - the
"representative consumer" or "representative firm".
In truth,
humans are highly social animals and our behaviour is hugely influenced
by those around us. We evolved to live in small groups, which has left
us with a powerful - if often unconscious - motivation to fit in with
the group and avoid being ostracised.
We feel most comfortable when
we're doing what everyone else is doing; we feel distinctly
uncomfortable when we're doing the opposite to everyone else. We feel
great loyalty to the groups we belong to, and rivalry and suspicion
towards groups we don't belong to.
This means humans - "economic
agents" as economists say - are prone to herd behaviour. At the most
innocuous level, this makes us heavily influenced by fashion. We like to
wear what others are wearing, read what others are reading and watch
the movies and TV shows that others are watching.
It's remarkable
that the business world could be so conscious of the need to accommodate
and, indeed, exploit our susceptibility to fashion while the economists
seek to analyse our behaviour using a model that assumes it away.
More
significantly, our tendency to herd behaviour affects the behaviour of
markets - particularly financial markets - in ways that, though we've
seen it happen many times before, almost invariably catch economists
unawares.
It's our propensity for "group-think" that does most to
explain booms and busts in the sharemarket, but also the upswings and
downswings in the economy. We swing from overly optimistic to overly
pessimistic, then back again, and we tend to all do it together.
A
separate aspect of the model's exclusive focus on the individual is its
overemphasis on competition and underemphasis on co-operation. It's
actually the human animal's unmatched ability to co-operate in solving
problems that has given our species its mastery over the planet.
Human
behaviour is composed of competition and co-operation. We form
co-operative groups so as to enhance their ability to compete with other
groups. But the economists' model captures only one dimension of the
process.
The classic example of group co-operation to facilitate
competition is, of course, that bedrock of modern economies, the
company. Companies - often very large, multinational companies -
dominate our economy, but the model tells us nothing about what goes on
inside them and economists don't have much to tell us about how the
existence of big companies affects the behaviour of markets.
The
final and perhaps most important twist that the economic model's focus on
individuals imposes on economists' thinking is an inbuilt bias against
intervention in markets by co-operation at its highest level,
government.
The market of individual consumers and individual
(tiny) firms is assumed to be self-sufficient and self-correcting, thus
making intervention by government something alien and more likely to
make things worse than better.
The reality, of course, is that
governments not only need to "hold the ring" - provide the protection of
property rights and legal enforcement of contracts - they also need to
impose rules that protect the market, and the rest of us, from the
consequences of its own herd-driven excesses.
