By Dr. Hassan Shirvani—Among the collateral\u00a0damages\u00a0of the recent global\u00a0economic\u00a0crisis has been the\u00a0reputation of the\u00a0economics profession\u00a0whose members famously\u00a0failed to anticipate the financial tsunami\u00a0that\u00a0rocked the world.<\/p>\n
Enmeshed in their\u00a0complex\u00a0mathematical models with their\u00a0highly\u00a0unrealistic assumptions,\u00a0most\u00a0economists were seemingly as stunned by the\u00a0suddenness and the\u00a0severity of the economic downturn as\u00a0the average person on the street. \u00a0Even Queen Elizabeth of England, on hearing about the destructive effects of the crisis,\u00a0admonished her economic experts as\u00a0to why \u201ceveryone had missed it.\u201d<\/p>\n
To better understand the reasons for their\u00a0analytical failure, many economists have been\u00a0searching for alternative economic models with\u00a0greater\u00a0explanatory and\u00a0predictive powers.\u00a0\u00a0Out of this chaotic state has emerged a renewed interest in a school of behavioral economics<\/a> which\u00a0advocates the use of psychology in economic analysis.<\/p>\n Rejecting the assumption of rationality favored by most\u00a0conventional\u00a0economists, the new school argues that most individuals are characterized by bounded\u00a0or limited\u00a0rationality<\/a>. \u00a0This simply means that most economic units\u00a0find it difficult to\u00a0process\u00a0the available\u00a0information\u00a0correctly\u00a0due to\u00a0their\u00a0cognitive shortcomings. \u00a0Most of us, in other words, are bad thinkers, making decisions that are often against our own\u00a0best interests. \u00a0In addition, behavioral economists assert that most individuals are subject to altruistic impulses and suffer from limited will powers, both of which are in violation of the standard economic assumptions that individuals are self-centered and self-controlled.<\/p>\n To support these\u00a0positions, behavioral economics often presents extensive laboratory-based experiments that tend to show that most humans are indeed subject to a host of cognitive\u00a0biases\u00a0and errors. \u00a0Examples of such\u00a0biases\u00a0include\u00a0addiction, myopia, overconfidence, procrastination and various framing effects.<\/p>\n There is no question that human behavior is far too complex to be captured by any simple model of rational choice. \u00a0\u00a0It is also true that many of us have our moments of bounded rationality. \u00a0For example, whenever we whistle while passing a graveyard at night, knock on wood as a protection against\u00a0bad eyes, or\u00a0refuse the advice of our spouses to stop our cars and ask for directions, we are in the throes of our cognitive glitches. \u00a0And yet, none of us believe that\u00a0just\u00a0because of these psychological issues, we are therefore incapable of making the right decisions for ourselves most of the time.<\/p>\n If this were true, humans would not have survived their seven million years of evolution.\u00a0\u00a0Indeed, many of our psychological traits, such as altruism, risk aversion, fear, and greed\u00a0have been developed as\u00a0defense mechanisms\u00a0to help us better survive\u00a0in our\u00a0mostly\u00a0hostile environments. \u00a0In addition, many of these cognitive issues have long been familiar to, and been taken advantage of, by marketers and politicians, among others. \u00a0While there are highly simplified models of economic behavior that assume hyper-rational and self-centered individuals, there are also more realistic models that do consider such traits as altruism and herd behavior. \u00a0At any rate,\u00a0it is\u00a0hard to\u00a0attribute\u00a0the recent global economic meltdown\u00a0to\u00a0psychological factors alone.<\/p>\n <\/p>\n Real Failure of\u00a0Economics<\/strong><\/p>\n In the light of the foregoing, the real problem with modern economics is hardly about whether economic agents are fully or only partially rational or whether they are decisive or not.\u00a0 Rather, it is the heavy emphasis placed by modern economics on individual economic behavior, to the almost total disregard for the economic, political, and social environments in which individuals operate. \u00a0For example, many individuals often act differently in isolation as opposed to a social setting. \u00a0That is why we have herd behavior for both consumers and investors. In addition, modern economics has long ignored the institutional characteristics of modern industrial economies, modelling them as though they were\u00a0no different from\u00a0small medieval villages.\u00a0 Under these conditions, there is little room left for giant corporations and powerful labor\u00a0unions to control prices and wages, or for hedge funds to manipulate the financial system through their access to privileged information. Likewise, modern economics largely glosses over the issue of economic inequality, relegating it to the domains of politics and sociology.All of the above omissions proved fatal to the existing economic models during the recent economic crisis, precisely at a time when they were needed to both explain\u00a0the onset of\u00a0the Great Recession and to devise policies to deal with its aftermath.\u00a0\u00a0In contrast, a\u00a0more appropriate\u00a0model\u00a0would have paid closer attention to the dynamic forces that were essential to the development and periodic crises\u00a0of\u00a0the global economic system. \u00a0In particular,\u00a0such a model should have recognized the role of\u00a0unbridled free markets and their associated deregulation of the economic and financial sectors in creating\u00a0the recent\u00a0environment of excessive\u00a0leverage and\u00a0risk taking, lax corporate governance, and widening\u00a0economic\u00a0inequalities. In addition, a more appropriate\u00a0model should have incorporated\u00a0the role of the recent\u00a0globalization\u00a0which, by providing access to\u00a0cheap foreign labor,\u00a0served to\u00a0lower domestic incomes in\u00a0many industrial economies. \u00a0It was partly to address this income shortfall that many\u00a0low and middle income consumers gorged\u00a0on\u00a0debt, thus setting the stage for the 2008 credit\u00a0crisis\u00a0and the subsequent crash of the world economy. Conclusion<\/strong><\/p>\n As the foregoing discussion makes it clear, the limited rationality of individuals, while causing deviations from their optimal economic behavior, is far from sufficient to account for major economic crises. \u00a0In other words, psychological factors are at best the icing on the cake. \u00a0It is far better to try to understand the\u00a0structural characteristics\u00a0and\u00a0the operational fragilities\u00a0of modern economic systems from an institutional perspective. \u00a0It is only through such an understanding that we may have a\u00a0reasonable\u00a0chance\u00a0of ever\u00a0coming up with sound economic policies to forestall any future\u00a0global economic\u00a0catastrophe.<\/p>\n Hassan Shirvani, Ph.D.<\/a>
\nBounded Rationality<\/strong><\/p>\n
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\nProfessor Cullen Foundation Chair in Economics<\/p>\n