Economics - Psychology's Neglected Branch
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
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"It is impossible to describe any human action if one does not
refer to the meaning the actor sees in the stimulus as well as in the end his
response is aiming at."
Ludwig von Mises
Economics - to the great dismay of economists - is merely a branch of psychology. It deals with individual behaviour and with mass behaviour. Many of its practitioners seek to disguise its nature as a social science by applying complex mathematics where common sense and direct experimentation would have yielded far better results. The outcome is an embarrassing divorce between economic theory and its subjects.
The economic actor is assumed to be constantly engaged in the rational pursuit of self interest. This is not a realistic model - merely a useful (and flattering) approximation. According to this latter day - rational - version of the dismal science, people refrain from repeating their mistakes systematically. They seek to optimize their preferences. Altruism can be such a preference, as well.
We like to believe that we are rational. Such self-perception is ego-syntonic. Yet the truth is that many people are non-rational or only nearly rational in certain situations. And the definition of "self-interest" as the pursuit of the fulfillment of preferences is a tautology.
The theory fails to predict important phenomena such as "strong reciprocity": the propensity to "irrationally" sacrifice resources to reward forthcoming collaborators and punish free-riders. It even fails to account for simpler forms of apparent selflessness, such as reciprocal altruism (motivated by hopes of reciprocal benevolent treatment in the future).
Even the authoritative and mainstream 1995 "Handbook of Experimental Economics", by John Hagel and Alvin Roth (eds.) admits that people do not behave in accordance with the predictions of basic economic theories, such as the standard theory of utility and the theory of general equilibrium. Irritatingly for economists, people change their preferences mysteriously and irrationally. This is called "preference reversals".
Moreover, people's preferences, as evidenced by their choices and decisions in carefully controlled experiments, are inconsistent. They tend to lose control of their actions or procrastinate because they place greater importance (i.e., greater "weight") on the present and the near future than on the far future. This makes most people both irrational and unpredictable.
Either one cannot design an experiment to rigorously and validly test theorems and conjectures in economics - or something is very flawed with the intellectual pillars and models of this field.
Finally, what is rational on the level of the individual consumer, household, firm, saver, or investor may be detrimentally irrational as far as the welfare of the collective goes. The famous "thrift paradox" is a case in point: in times of crisis, it makes sense to consume less and save more if you are a household or firm. However, the good of the economy as a whole requires you to act irrationally: save less and go on frequent shopping sprees.
Neo-classical economics has failed on several fronts simultaneously. This multiple failure led to despair and the re-examination of basic precepts and tenets.
Consider this sample of outstanding issues:
Unlike other economic actors and agents, governments are accorded a special status and receive special treatment in economic theory. Government is alternately cast as a saint, seeking to selflessly maximize social welfare - or as the villain, seeking to perpetuate and increase its power ruthlessly, as per public choice theories. Both views are caricatures of reality. Governments indeed seek to perpetuate their clout and increase it - but they do so mostly in order to redistribute income and rarely for self-enrichment.
Still, government's bad reputation is often justified:
In imperfect or failing systems, a variety of actors and agents make arbitrage profits, seek rents, and accrue income derived from "facilitation" and other venally-rendered services. Not only do these functionaries lack motivation to improve the dysfunctional system that so enriches them - they have every reason in the world to obstruct reform efforts and block fundamental changes aimed at rendering it more efficient.
Economics also failed until recently to account for the role of innovation in growth and development. The discipline often ignored the specific nature of knowledge industries (where returns increase rather than diminish and network effects prevail). Thus, current economic thinking is woefully inadequate to deal with information monopolies (such as Microsoft), path dependence, and pervasive externalities.
Classic cost/benefit analyses fail to tackle very long term investment horizons (i.e., periods). Their underlying assumption - the opportunity cost of delayed consumption - fails when applied beyond the investor's useful economic life expectancy. People care less about their grandchildren's future than about their own. This is because predictions concerned with the far future are highly uncertain and investors refuse to base current decisions on fuzzy "what ifs".
This is a problem because many current investments, such as the fight against global warming, are likely to yield results only decades hence. There is no effective method of cost/benefit analysis applicable to such time horizons.
How are consumer choices influenced by advertising and by pricing? No one seems to have a clear answer. Advertising is concerned with the dissemination of information. Yet it is also a signal sent to consumers that a certain product is useful and qualitative and that the advertiser's stability, longevity, and profitability are secure. Advertising communicates a long term commitment to a winning product by a firm with deep pockets. This is why patrons react to the level of visual exposure to advertising - regardless of its content.
Humans may be too multi-dimensional and hyper-complex to be usefully captured by econometric models. These either lack predictive powers or lapse into logical fallacies, such as the "omitted variable bias" or "reverse causality". The former is concerned with important variables unaccounted for - the latter with reciprocal causation, when every cause is also caused by its own effect.
These are symptoms of an all-pervasive malaise. Economists are simply not sure what precisely constitutes their subject matter. Is economics about the construction and testing of models in accordance with certain basic assumptions? Or should it revolve around the mining of data for emerging patterns, rules, and "laws"?
On the one hand, patterns based on limited - or, worse, non-recurrent - sets of data form a questionable foundation for any kind of "science". On the other hand, models based on assumptions are also in doubt because they are bound to be replaced by new models with new, hopefully improved, assumptions.
One way around this apparent quagmire is to put human cognition (i.e., psychology) at the heart of economics. Assuming that being human is an immutable and knowable constant - it should be amenable to scientific treatment. "Prospect theory", "bounded rationality theories", and the study of "hindsight bias" as well as other cognitive deficiencies are the outcomes of this approach.
To qualify as science, economic theory must satisfy the following cumulative conditions:
Many current economic theories do not meet these cumulative criteria and are, thus, merely glorified narratives.
But meeting the above conditions is not enough. Scientific theories must also pass the crucial hurdles of testability, verifiability, refutability, falsifiability, and repeatability. Yet, many economists go as far as to argue that no experiments can be designed to test the statements of economic theories.
It is difficult - perhaps impossible - to test hypotheses in economics for four reasons.
In a way, economics has an affinity with some private languages. It is a form of art and, as such, it is self-sufficient and self-contained. If certain structural, internal constraints and requirements are met – a statement in economics is deemed to be true even if it does not satisfy external (scientific) requirements. Thus, the standard theory of utility is considered valid in economics despite overwhelming empirical evidence to the contrary - simply because it is aesthetic and mathematically convenient.
So, what are economic "theories" good for?
Economic "theories" and narratives offer an organizing principle, a sense of order, predictability, and justice. They postulate an inexorable drive toward greater welfare and utility (i.e., the idea of progress). They render our chaotic world meaningful and make us feel part of a larger whole. Economics strives to answer the "whys" and "hows" of our daily life. It is dialogic and prescriptive (i.e., provides behavioural prescriptions). In certain ways, it is akin to religion.
In its catechism, the believer (let's say, a politician) asks: "Why... (and here follows an economic problem or behaviour)".
The economist answers:
"The situation is like this not because the world is whimsically cruel, irrational, and arbitrary - but because ... (and here follows a causal explanation based on an economic model). If you were to do this or that the situation is bound to improve".
The believer feels reassured by this explanation and by the explicit affirmation that there is hope providing he follows the prescriptions. His belief in the existence of linear order and justice administered by some supreme, transcendental principle is restored.
This sense of "law and order" is further enhanced when the theory yields predictions which come true, either because they are self-fulfilling or because some real "law", or pattern, has emerged. Alas, this happens rarely. As "The Economist" notes gloomily, economists have the most disheartening record of failed predictions - and prescriptions.
The Dismal Mind - Economics as a Pretension to Science
Immortality and Mortality in the Economic Sciences
The Misconception of Scarcity
The Merits of Inflation
Anarchy as an Organizing Principle
Relativity Theory in Economics by José Martins Barata
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