The Trouble with Economics

Here are some bits from a post by Dan Ariely, a behavioural economist, discussing the problems with the dominant economic theory under which politicians and business is conducted:

Neoclassical economics is built on very strong assumptions that, over time, have become “established facts.” Most famous among these are that all economic agents (consumers, companies, etc., are fully rational, and that the so-called in- visible hand works to create market efficiency). To rational economists, these assumptions seem so basic, logical, and self-evident that they do not need any empirical scrutiny.

Building on these basic assumptions, rational economists make recommendations regarding the ideal way to design health insurance, retirement funds, and operating principles for financial institutions. This is, of course, the source of the basic belief in the wisdom of deregulation: if people always make the right decisions, and if the “invisible hand” and market forces always lead to efficiency, shouldn’t we just let go of any regulations and allow the financial markets to operate at their full potential?

On the other hand, scientists in fields ranging from chemistry to physics to psychology are trained to be suspicious of “established facts.” In these fields, assumptions and theories are tested empirically and repeatedly. In testing them, scientists have learned over and over that many ideas accepted as true can end up being wrong; this is the natural progression of science. Accordingly, nearly all scientists have a stronger belief in data than in their own theories. If empirical observation is incompatible with a model, the model must be trashed or amended, even if it is conceptually beautiful, logically appealing, or mathematically convenient.

Unfortunately, such healthy scientific skepticism and empiricism have not yet taken hold in rational economics, where initial assumptions about human nature have solidified into dogma. Blind faith in human rationality and the forces of the market would not be so bad if they were limited to a few university professors and the students taking their classes. The real problem, however, is that economists have been very successful in convincing the world, including politicians, businesspeople, and everyday Joes not only that economics has something important to say about how the world around us functions (which it does), but that economics is a sufficient explanation of everything around us (which it is not). In essence, the economic dogma is that once we take rational economics into account, nothing else is needed.

I believe that relying too heavily on our capacity for rationality when we design our policies and institutions, coupled with a belief in the completeness of economics, can lead us to expose ourselves to substantial risks.

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What I find amazing is that when it comes to designing the mental and cognitive realm, we somehow assume that human beings are without bounds. We cling to the idea that we are fully rational beings, and that, like mental Supermen, we can figure out anything. Why are we so readily willing to admit to our physical limitations but are unwilling to take our cognitive limitations into account? To start with, our physical limitations stare us in the face all the time; but our cognitive limitations are not as obvious. A second reason is that we have a desire to see ourselves as perfectly capable— an impossibility in the physical domain. And perhaps a final reason why we don’t see our cognitive limitations is that maybe we have all bought into standard economics a little too much.

Don’t misunderstand me, I value standard economics and I think it provides important and useful insights into human endeavors. But I also think that it is incomplete, and that accepting all economic principles on faith is ill-advised and even dangerous. If we’re going to try to understand human behavior and use this knowledge to design the world around us—including institutions such as taxes, education systems, and financial markets—we need to use additional tools and other disciplines, including psychology, sociology, and philosophy. Rational economics is useful, but it offers just one type of input into our understanding of human behavior, and relying on it alone is unlikely to help us maximize our long- term welfare.

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For instance, in my ideal world, before implementing any public policy—such as No Child Left Behind or a $130 billion tax rebate or a $700 billion bailout for Wall Street—we would first get a panel of experts from different fields to propose their best educated guess as to what approach would achieve the policy’s objectives. Next, instead of implementing the idea proposed by the most vocal or prestigious person in this group, we would conduct a pilot study of the different ideas. Maybe we could take a small state like Rhode Island (or other places interested in participating in such programs) and try a few different approaches for a year or two to see which one works best; we could then confidently adopt the best plan on a large scale. As in all experiments, the volunteering municipalities would end up with some conditions providing worse outcomes than others, but on the plus side there would also be those who would achieve better out- comes, and of course the real benefit of these experiments would be the long-term adoption of better programs for the whole country.

I realize that this is not an elegant solution because con- ducting rigorous experiments in public policy, in business, or even in our personal lives is not simple, nor will it provide simple answers to all of our problems. But given the complexity of life and the speed at which our world is changing, I don’t see any other way to truly learn the best ways to improve our human lot.

The US is paying a nearly $2 trillion dollar price tag for believing in neoclassical dogma and buying into the "deregulate, deregulate, deregulate" philosophy of this flawed model of homo economicus and the efficiencies of markets. Sadly, the above realization has not yet made it onto the political agenda. A person like Obama still listens to those who sell the old snake oil of neoclassical economics.