Are people unreasonable in that we make bad decisions, or simply irrational in that we rarely use formal, quantitative analysis? Are investors' profit expectations inviolable? Are Americans playing the same hand of economic cards that we held in the mid-20th century?
These are the three "big questions" I offer in my critique of Nobel Prize-winning economist George Akerlof and co-author Robert Shiller's new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. While I agree with most of their ideas, these unanswered questions weaken their argument.
More below the fold....
Animal Spirits, Part IV - Conclusion and Critique
This week, Morning Feature has explored Akerlof and Shiller's new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Wednesday we considered their rebuttal of the myth of the Rational Economic Actor. Thursday we examined their answers to four "big questions" of recessions, banking, unemployment, and inflation. Yesterday we looked at their other four "big questions" of savings, investment volatility, real estate cycles, and minority poverty. Today we conclude with a critique.
George Akerlof and Robert Shiller have drawn on some intriguing research in their new book. The emerging field of neuroeconomics, which is based less on guesswork and assumptions about human behavior and more on scientific study of human decision-making, could be a real step forward in reducing the dominance of ideology in economic theory.
But the rigor and promise of empirical science is limited by the assumptions scientists' bring into their work. If you set out to test A&B→C, you're less likely to stumble upon (A|B)&D→C, as you're not measuring and may not even have considered the relevance of D. Akerlof and Shiller seem to bring some assumptions into their research, treating them as givens. They don't explain why these assumptions are givens. Some are mentioned only in passing, and others not at all. But they are as fundamental to the authors' theory as the Rational Economic Actor and Efficient Markets are to classical and neoclassical theories.
As the meat of Akerlof and Shiller's book was their approach to their eight "big questions," I'll frame my critique in terms of my own three "big questions." The answers to these questions matter. Even more important, to me, is the act of considering them and challenging the assumption implicit in each.
Are we unreasonable, or simply irrational?
Unreasonable and irrational may seem like synonyms, but they're not in economic terms. In economic theory, rational seems to have a specific meaning. It refers to decisions reached through formal, quantitative analysis, i.e.: using precise, measured data in economic and game theory equations to calculate expectations of profit and risk. In that sense, most of us are irrational; we use estimates and intuition rather than quantitative analysis. But does that mean we're unreasonable?
Ironically, neuroscience suggests the answer may be yes, that we are indeed unreasonable, when we listen to experts. That study, published in March 2009, found that the parts of the brain responsible for estimating and weighing probabilities "offloads" when we're exposed to expert advice. Rather than estimating and weighing probabilities for ourselves, we accept experts' estimates and weightings as facts, even when they're wrong. The authors conclude this reflects a bias in favor of conformity to an authoritative expert.
Experts are often wrong, and indeed that's the central premise of Akerlof and Shiller's theory: classical and neoclassical economics are grounded on false assumptions about human behavior. Yet their tacit assumption is that this reflects a weakness in our decision-making. They don't seem to consider the possibility that our intuitive reasoning might be as good as their quantitative analysis, and that the differences may reflect missing factors in their equations rather than our unreasonableness.
Are investors' profit expectations inviolable?
While Akerlof and Shiller frame their theory in terms of ensuring full efficient employment, investors' profit expectations seem to be as much a sine qua non in their theory as in classical and neoclassical theories. They often criticize workers' wage expectations - e.g.: that we're unwilling to lower wage expectations even when prices are falling - but never question investors' profit expectations. It may be that they have data to support their tacit assumption that investors must be able to expect at least 7% return on investment, but they don't present that data or even address the question. That investors must be confident of a "large profit" is stated as a given.
I suggest any economic theory that holds a small group's expectations as inviolable while arguing that the mass of people must sacrifice whatever is necessary to meet that small group's expectations - without any proof that this balance is essential for a healthy economy - is a theory still mired in false assumptions. That is especially true in light of the third unanswered question.
Are we holding the same cards we held in the 1950s?
All other things being equal, there are sound strategies for playing certain hands in poker. Those strategies may not work every time, and exceptional conditions at the table may require variations, but they are mathematically sound strategies given those specific cards-in-hand. The key phrase there is "those specific cards-in-hand," because of course the strategies change depending on which cards you're holding. But in poker, unlike in economics, we know when we've been dealt a new hand.
Akerlof and Shiller seem to make the tacit assumption that Americans still hold the same economic cards we held in the 1950s. They make no mention of changes in conditions - peak domestic oil, rising competition as Europe and Japan rebuilt after World War II - that were happening by the early 1970s, and only a passing mention of world peak oil and climate change. They classify warnings about diminishing resources and climate change as stories, and subtly imply that because dire stories were wrong in the past we're irrational to believe them now. Their conclusion is that government must step in to counter both optimism and pessimism - as if neither is ever really justified - to maintain stability.
But what if our cards have changed? There is good science to suggest we Americans do not hold the same cards we held in the 1950s, and that all of us - including investors - need to revise our expectations in light of those changed conditions. By ignoring those changed conditions, and by holding investors' expectations inviolate, Akerlof and Shiller risk their theory being used as a rationale to squeeze the last hopes out of workers in order to guarantee investors their last pennies of profit.
And in light of the overall tone of their theory and its recommendations, I don't think that's what Akerlof and Shiller really want. In order to safeguard their theory from abuse, they need to answer these three "big questions."
Because at its core, their theory is all about the dangers of taking our assumptions for granted.