It’s a red letter day for economics. Richard Thaler has been awarded the Nobel Prize for Economics.
This is not just any old economics prize. Richard Thaler pioneered behavioural economics based on the idea that Homo Economicus, the rational being optimising economic value in all decision making, is a fiction created by classical economics and bears little or no resemblance to how people behave in real life. In 2002, the Nobel prize in economics was awarded to Daniel Kahneman – a psychologist. “His empirical findings challenge the assumption of human rationality prevailing in modern economic theory.”
For years, classical economists have grudgingly realised that their discipline was based on quicksand – if it is as stable as that. The “rational” economic being was created not because it represented human beings in any way but because it was the way in which it made possible the use of mathematics in economic models. Yes, the professors argued, we know it’s not a faithful representation of what’s going on. But these are models, they are necessarily reductive, and if we make a few (harmless) assumptions about rationality, then we can represent everything in neat mathematics.
The central role that economics and macroeconomic models play in policy making is hard to over-estimate. The fundamental assumptions made by the economics profession end up affecting all our lives. “Imperfections” are to be expected in any type of modelling exercise. But it’s a far cry from imperfect assumptions to accepting the now indisputable fact that the foundations on which the whole discipline is based are fundamentally flawed.
Let us take the assumptions underlying central bank policies. Low interest rates are suppose to encourage investment and consumer expenditure. It turns out that those effects are largely peripheral. Companies do not invest because interest rates are low. They invest based on their confidence of making future returns on those investments. When loose monetary policy is prolonged, as it now has been for years, the main signal given to business is that the economy is persistently weak. Companies react as we have seen – they don’t invest, but use low interest rates to borrow in order to undertake massive share buybacks. The result – a surge in stock prices in spite of a weak real economy and low investment.
As for consumers, as Thaler pointed out, they behave according to their personal circumstances, biases and prejudices. A multiplicity of behaviours ensues with an aggregate effect that has very little in common with that predicted by macroeconomic models.
Of course, some, though by no means all, in the economics profession have accepted the need to think behaviourally rather than mathematically. But much of the effect has focused on attempts to ‘refine’ macroeconomic models to take account of behavioural factors. So far we have not seen the start of an acceptance that the whole house of cards is flawed and needs re-thinking from the bottom up.
Of course, that is a scary prospect. Admitting that much of our policy-making is based on a flawed fiction, while not yet having anything else to put in its place, is not an attractive proposition. Not to mention the impact on all the careers, prizes, research grants and expressed authority that such an admission could entail.
The result is an attempt at retro-fitting behavioural issues onto existing macroeconomic models. “Incorporating behavioural assumptions into macroeconomic models is not without its problems” (Driscoll and Holden). Really! What a surprise.
Needless to say, that is not good enough. The UK does have its Behavioural Insights Team (previously the Cabinet Office “Nudge Unit”) to try to apply some of the lessons from behavioural science. But its work is hardly mainstream in policy-making. A search on behavioural economics on the HM Treasury website was, to say the least, disappointingly bare.
So where do we go from here? Hard to know. My own view is that it’s time we stopped taking classical economists and their macroeconomic models quite as seriously as we do. Policy-makers need to be more sceptical and more questioning when they take advice. They should make sure that they get input from a wide variety of people with different perspectives and different approaches. Complexity and behavioural sciences are moving forward at a fast pace and, if embraced, might improve how policy is made and implemented.
Those who have made their careers on the classical ladder will not, of course, give up their power quickly or quietly. Policy-makers will also be hesitant to dive into what might look like an unknown abyss even as they come to realise that the known is largely fake.
It will take time. But in awarding these Nobel prizes, the Royal Swedish Academy of Sciences have done their best to push the process forward.
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