There are plenty of economists who will happily admit the limits of their discipline, and be nominally open to the idea of other theories. However, I find that when pushed on this, they reveal that they simply cannot think any other way than roughly along the lines of neoclassical economics. My hypothesis is that this is because economist’s approach has a ‘neat and tidy’ feel to it: people are ‘well-behaved’; markets tend to clear, people are, on average, right about things, and so forth. Therefore, economist’s immediate reaction to criticisms is “if not our approach, then what? It would be modelling anarchy!”
One such example of this argument is Chris Dillow, in his discussion of rationality in economics:
Now, economists have conventionally assumed rational behaviour. There’s a reason for this.Such an assumption generates testable predictions, whereas if we assume people are mad then anything goes.
However, as I and others have pointed out, people do not have two mindsets: ‘rational’, where they maximise utility, and ‘irrational’, where they go completely insane and chuck cats at people. People can behave somewhat predictably without being strictly ‘rational’, in economists sense of the word, and falsifiable predictions and clear policy prescriptions can be made based on this behaviour.
One example of this is Daniel Kahneman’s ‘Type 1′ versus ‘Type 2′ thinking. Type 1 thinking is basically the things you do without thinking: making a cup of tea, walking, breathing. People use a lot of mental shortcuts and heuristics with Type 1 thinking, helping to avoid lengthy calculations for everyday actions. Type 2 thinking, on the other hand, is the type of thinking one does when learning something new or solving a problem. It is far slower and more careful, and time consuming. Hence, it is saved only for things that are new and/or important.
So what are the implications of this? Well, there are many, but a major thing it helps to explain are implied contracts. Most purchases do not require one to sign a contract, and even when one is signed, who really has the time or expertise to read through the whole thing? So studying how people think – or don’t – when engaging in everyday transactions can help courts decide what exactly they have agreed to. In fact, the Type 1/Type 2 disparity highlights an opportunity for exploitation: a company with a large legal department who can draft the terms of doing business with them, using ‘Type 2′ thinking, has an obvious advantage over a customer who wants to get in and out and has many other things to think about. Such considerations could be highly relevant when deciding whether or not someone ‘agreed’ to certain addons when buying a credit card.
So the discussion of rationality versus irrationality is something of a red herring. Yet I expect economists will still question how we can model people’s economic behaviour if we don’t appeal to some semi-rational ordering of preferences. This mentality was reflected in my comments by an occasional sparring partner of mine, Luis Enrique:
Even if you tried to discard utility…you would end up implicitly appealing to some thing very similar to utility (which is just a convenient means of representing preferences) if you want to say anything about what people buy at what prices.
The issue here is that economists are predisposed to believe that we need to appeal to individual preferences to understand consumption. They will then assert that all utility really requires is that people have preferences and that they don’t order them nonsensically, and ask what exactly the problem with utility is.
However, as I have previously argued, utility does not only require that preferences are complete, transitive and so forth, but also that they are fixed: that is, individuals have a set of preferences that remain the same for at least long enough to be useful for analysis (and in some neoclassical models, preferences are the same for an agent’s entire lifespan). However, evidence suggests that individual preferences are highly volatile, differing across time and being highly dependent on situation. How exactly could something so hard to pin down be useful?
The truth is that most preferences are shaped by social conventions, by situations and by how they are presented to the consumer. What’s more, these things tend to stick around longer than individual preferences. Fashion is the most obvious example here: ultimately, this season’s trends are determined by a relatively small group of people in key companies, and consumers simply copy everyone else. In many ways the individual preference does not exist; it is created by circumstance and copied. If we want to understand fashion choices there is little to be gained from building a model around a utility maximising individual in a vacuum: we can simply look at trends and assume a certain proportion of people will follow them. In other words, like all of economics, the micro level needs macrofoundations.
The economist’s mentality extends up to the highest echelons of economics modelling, and culminates in the ‘DSGE or die’ approach, described well on Noah Smith’s blog by Roger Farmer:
If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, … I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.
This spurred a puzzled rebuttal from J W Mason:
The thing about the equilibrium approach, as Farmer presents it, isn’t just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition.
When questioned about his approach, Farmer would probably suggest that if we do not assume markets tend to clear, and that agents are, on average, correct, then what exactly do we assume? A harsh evaluation would be to suggest this is really an argument from personal incredulity. There is simply no need to assume markets tend to clear to build a theory – John Maynard Keynes showed us as much in The General Theory, a book economists seem to have a hard time understanding precisely because it doesn’t fit their approach. Furthermore, the physical sciences have shown us that systems can be chaotic but model-able, and even follow recognisable paths.
A great, simple and testable disequilbirium theory was given to us by Hyman Minsky with his Financial Instability Hypothesis. His idea was that in relatively stable times, investors and firms will make good returns on their various ventures. Seeing these good returns, they will decide that in the next period, they will invest a little more; take a little more risk; borrow a little more money. As long as they generate returns, this process will continue and the average risk-taking will increase. Eventually – and inevitably – some investors will overextend themselves into debt-fuelled speculation, creating bubbles and crashes. Once this has settled everyone will be far more cautious and the whole thing will start again. Clearly, constructing a disequilibrium scenario is not intellectual anarchy: in fact, the actors in this scenario are behaving pretty rationally.
Ultimately, the only thing stopping economists exploring new ideas is economists. There is a wide breadth of non-equilibrium, non-market clearing and non-rational modelling going on. Economists have a stock of reasons that these are wrong: the Lucas Critique, Milton Friedman’s methodology, the ‘as if‘ argument and so forth. Yet they often fail to listen to the counterarguments to these points and simply use them to defer to their preferred approach. If economists really want to broaden the scope of the discipline rather than merely tweaking it around the edges, they must be prepared to understand how alternative approaches work, and why they can be valid. Otherwise they will continue to give the impression – right or wrong – of ivory tower intellectuals, completely out of touch with reality and closed off from new ideas.