Last summer, the whole “intellectual edifice collapse[d]”. This statement, delivered to a Congressional committee just under a year ago, starkly illustrates the shock and confusion which overtook much of the field of economics in the last two years in the wake of the financial crisis.
The fact that it came from Alan Greenspan, former head of the US central bank, the Federal Reserve, one of the most well-known and respected economists in the world only underlined its significance: for a figure of his stature to make such a statement would have been unthinkable even a year before.
The edifice he referred to is that of neoclassical economics, the school of thought that has informed much of economic thinking (and the Fed’s policies) in recent decades. Intellectually rooted in the laissez-faire economic ideas of the 19th century, neoclassicism expands these into the 21st through the theory of efficient markets, a set of complex yet elegant mathematical and statistical models explaining economic behaviour. Yet this cleanness and elegance, so attractive to the theoretical mind, comes at the price of comprehensiveness. Central to the theory is the assumption of rationality on the part of everyone involved: investors are informed, responsible people who soberly weigh up every alternative and balance all the rewards against all the financial hazards.
These “Economic Men” were the reason why few economists were particularly worried by the prospect of an economic bubble, or the increasingly risky strategies (such as sub-prime mortgage lending) proliferating in the years leading up to 2008. Rational homebuyers would not buy houses which were vastly overpriced. Rational lenders would not provide them with mortgages which they could not repay. Rational investors would not pour billions of dollars into institutions which supported such patently irrational practices. And exceptions to these rules, if they existed at all, were anomalies whose “noise” could not drown out the majority of sensible economic actors in a sensible market.
Until, as Paul Krugman, last year’s Nobel laureate in Economics bluntly put it, “everything came apart.” In a matter of months the financial world was overtaken by its greatest crisis since the Great Depression, in circumstances which leading experts in the field had dismissed as unlikely or even impossible. Not surprisingly, the aftermath of the crisis has triggered much soul-searching in finance and in economics generally. The questions of what went wrong, how it went wrong and (most importantly) why so few people predicted it, have been asked again and again as the world watched virtually every developed economy in the world slide into recession.
The answers, of course, are complex, open to debate, and certainly can’t be reduced to a single cause. There are many lessons to be learned, and it is hardly surprising that the most noticeable teachers have been those few voices in the wilderness who did, in fact, question the direction in which financial markets were heading and the wisdom of the government policy that facilitated them. This has resulted in the emergence or return to prominence of a number of schools and theories critical of neoclassical assumptions, but perhaps the most prominent have been those attacking the naïveté of the idea of Economic Man and his perfect rationality. These commentators draw their ideas primarily from the discipline known as behavioural economics.
Behavioural economics (behavioural finance when applied specifically to financial markets) is an economic approach which seeks to integrate the insights of psychology into economic theory, particularly with regard to rationality and decision making. Cognitive investigations into the way human beings reason and make decisions have uncovered an extensive catalogue of biases and logical errors to which even the most reasonable of people fall prey to, and many of them are obviously relevant to economic behaviour: the tendency of people’s thinking to be disproportionately affected by even mild negative outcomes, for example, or the tendency to disregard chance as an explanation for even the briefest strings of success (known as the hot-hand fallacy) Likewise, classical thinking asserted that a majority of rational individuals should aggregate to a rational whole, but social psychology has much to say about the differences between our thinking and behaviour when isolated and when in the midst of an energetic group activity being engaged in by millions and commented on by millions more (like, say, financial trading).
Even the most sensible of us can be swept along in floods of herd behaviour, unwarranted exuberance or irrational panic based upon little more than the reactions of everyone else. And in recent years a strong interest has emerged in the application of neuroscientific findings made possible by medical imaging technology to economic problems (a field known, perhaps not surprisingly, as Neuroeconomics) with results as varied as the link between serotonin levels in the brain and our propensity to make risky decisions and the observation (which anyone standing in a Wall Street trading floor up until very recently couldn’t fail to notice) that the world of finance needs more women, as they may well be less affected by bouts of aggressive and irrational optimism than their testosterone-fuelled male counterparts. It has been the failure of classical economists to acknowledge the inner workings of the mind, let alone understand them, which has drawn the most criticism. But luckily serious attempts are being made to address this hole in economic theory.
Behavioural economics as a field has risen to prominence only relatively recently (one of the Noble Economics laureates in 2002, Daniel Kahneman, is a psychologist) but it has already provided economists of all persuasions with considerable food for thought, and will certainly continue to do so as it matures in the spotlight of widespread consideration. Still, it’s worth pointing out that its contribution is for the most part an evolution, rather than a revolution, of contemporary economic thought: it does not so much seek to discredit or disprove classical economic theory as to revise and augment it.
Few would argue that human beings are completely, or even mostly, irrational or incapable of sound judgement, just that they are not the perfectly rational Economic Men that efficient market theory would have us believe. Greenspan’s exclamation was perhaps, in the end, more an overstatement borne of shock (and the grilling of the notoriously combative representative Henry Waxman) than an admission that economics as we know it is dead: its basic principles are sound, the dictums of Adam Smith as relevant as they ever were. But amidst all the soul-searching of the last year and the flurry of new practices and government reforms that followed it, it’s clear that economists and policymakers must learn many lessons if this last financial disaster is never to recur, and the lessons of behavioural economics may prove the most important of them all.