Robert Thaler

For a subject as dry and mathematically inclined as economics, at least in its orthodox version, the linkage between the real world an the merely imaginary is more tenuous than most laypeople would think.

This occurred to me today when I read an excellent letter in the Financial Times. In it an MIT lecturer talks about how limited the average person’s grasp of rational choice is. We are mostly quite irrational even though we often try to be very sensible in our decision making.

“Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.”

This is, of course, not news to any of us. That’s why many of us find it quite difficult to make decisions about even trivial aspects of life.

The so-called ‘Paradox of Choice’ is a good example. [See Barry Schwartz’s book] Economists theorize that giving consumers a myriad choices will, inevitably, produce the best result: the more choice, the more likely that a consumer will find something that exactly matches what they want.

But this flies in the face of our evolutionary roots. We are not cognitively equipped to get into finely grained decision making, where we are required to evaluate nuanced differences. We are it bit brutish in our thinking. We are equipped for simple and often binary decision making: the kind of on-the-fly type of thinking that primitive animals have to make in order to survive to live another day. So when confronted by a plethora of choices most of us simply freeze up and avoid making any choice at all.

A practical example of this is the supermarket. Researchers have shown that someone going to the supermarket with a specific purchase in mind – say toothpaste – will often turn around and leave if there are too many varieties, flavors and brands on the shelf. It is better, in other words, for the shelf to sport a quite limited choice. Sales will be higher and consumers happier.

Contrast this real world research finding with the assumption within free market economic theory that consumers are ‘perfectly rational’, and we can start to comprehend why economics is such a mess. It is more astrology than science.

The entire edifice of free market theory rests on the notion that you and I are supreme calculators. That we are not defeated by shelf loads of products, but that we are capable of feats of analysis, consciously or not, that allow us to arrive at extraordinarily precise decisions that inevitably lead us to maximize our welfare. We never make mistakes. Never.

Sound familiar?

No, I didn’t think so.

I realize it seems very dull, but I want to reiterate the importance of of this small example: our economic lives have been run for years by people who’s outlook on life is conditioned by, and depends upon, on exactly the theory derived from assumptions like that of ‘perfect rationality’.

Take away perfect rationality, and the superiority of markets, as opposed to, say, governments, as allocators of scarce resources crumbles. That means no one can ‘prove’ that markets left to their own devices will always outperform the government.

So the debate reverts to a political one.

Which is why it is urgent that economics recovers itself from the dead end it was driven into seventy years ago and abandons most of the thinking accumulated since then. It simply isn’t true. Worse: it leads to severely handicapped public policy making. It allows ideologues like Reagan and Bush to slam the government – which is their right from an ideological perspective – from within an aura of scientific discipline.

There are times when markets are terrible – sub-prime mortgages anyone?

Bubbles are common structure within capitalist economies. So are business firms. But both bubbles and firms cannot exist within the purity of orthodox economics. Perfection has no room for the messiness of either.

The Nobel prize winner Ronald Coase pointed out to his economics colleagues in 1937 that since business firms seem to be quite common the profession ought to re-consider its allegiance to perfection. Instead he was ignored for decades and only much later did a subculture sprang up inside the profession studying firms. But the textbooks remain pristine. Indeed the firm as an economic entity remains a curiosity and is ignored by most academics.

So too with bubbles. Visit most academic economist websites and you will find all sorts of opinions as to why bubbles cannot be predicted. Many will deny they exist – even now. This is because they are all so inculcated with the perfectionist view that they fail to see the real world. And rather than admit their subject has a big hole in it, they attempt to explain away the Emperor’s nakedness by resorting to all sorts of arcane and highly jargon laden reasoning.

Economists have even begun to argue that their inability to reject a negative argument against their own theory is sufficient to justify its continued existence. Think about that: they take the fact that they have nothing to say as support for a theory. This is hardly Popperian refutation. It is vacuous.

The fact remains that economists are faced with a choice: either their subject is failing to explain many very common economic structures; or it is akin to astrology.

There are hopeful signs: people like Robert Thaler, mentioned in the letter I referenced at the beginning of this post, are slowly chipping away at the outmoded and mechanistic thinking that supports the orthodox theory. But they have a very long way to go.

Meanwhile ideologues still latch onto the orthodox theory in order to justify their politically motivated views. Which affects all of us. The current debate about health care reform would be so much more sensible were it rooted in real world claims about the efficacy of markets rather than being supported by an orthodoxy that resembles the reading of star charts.

So too would the re-regulation of banking.

The relevance of economic theory has never been greater. That’s why it is fun to get involved in the debate. In large part, the crisis we are living through is a creation of orthodox theory. Which is why it’s protagonists are so vocal in their attempts to misdirect our attention: Robert Lucas, Martin Feldstein, Robert Barro, John Taylor, and many others are constantly popping up in the media to pull the wool over our eyes. Their common theme is that it is the government’s fault. Or, failing that, they throw their hands up and claim that no one, absolutely no one, could possibly have seen the crisis arising.

They protest too much.

Their economics is beautiful. Intricate. Intense. Intellectually fascinating. Difficult to master. Brilliantly conceived. And about as scientific as astrology.

Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.

So with respect to the discussion over whether Bernanke should be re-appointed as Fed chairman: only if he was born under a propitious sign. Turns out he’s either Sagittarius or Capricorn. It is quite obvious that the Fed has far too many of those already. Time for one of us more solid, some would say dull, Taureans?