Sunday, June 23, 2024
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The weak link in economics

The science of economics has always been a mystery for the layman, but the strange thing is that it has never been an unambiguous discipline, even for those who trained to be professional economists.

To further complicate matters, regardless of our understanding of economics, we continue to adhere to it! “Poverty can put you in a difficult state of mind, and a difficult state of mind can make it more difficult to escape poverty,” Jamele Rigolini once said.

Most principles of economics are built on a simplified model of human behavior, which economists call the “homo economicus”. Although John Stuart Mill did not coin the term, the concept of the economic man was first introduced through his famous book, “The Principles of Political Economy“.

He even defines what the “economic man” is in his essay titled “On the Definition of Political Economy and on the Method of Investigation Proper to It.” According to Mill, political economy perceives humans from a narrower angle: “It is concerned with him [man] solely as a being who desires to possess wealth and who is capable of judging the comparative efficacy of means for obtaining that end.”

It is a concept in many economic theories that assumes humans as agents with narrowly well-defined self-interest who have the ability to make judgments toward their subjectively defined ends. The most notable aspect of this assumption is that the choices of the economic man are marked by rationality. Hence, according to most economists and economic principles, the economic man is a rational and profit-motivated man.

Because of this age-old principle in the science of economics, mainstream economists implicitly assume that the “economic man” is perfectly informed, rational, makes all kinds of optimal decisions, and can be squeezed into mathematical models that describe the aggregate supply and demand. How simple life would have been if this gravely erroneous postulation was right! The truth is that people simply don’t behave the way homo economicus would have them behave.

Lucky for us, now the big players in the world’s economy are becoming aware of the illusions of homo economicus. The recent World Bank Development Report is a witness to this awakening, and there is no one better than the president of the bank to announce it.

Many development economists and practitioners believe that the “irrational” elements of human decision-making are inscrutable or that they cancel each other out when large numbers of people interact, as in markets, according to Jim Yong Kim, who says recent research has advanced the understanding of the psychological, social, and cultural influences on decision-making and human behavior and has demonstrated that they have a significant impact on development outcomes.

The faulty rationale of homo economicus is now under revision by a relatively younger branch of economics called behavioral economics. This is an interdisciplinary field that links cognitive science and economics. It tries to answer the age-old question: What are the factors behind an individual’s decision? Broadly speaking, it refers to the attempt to increase the explanatory and predictive power of economic theory by providing it with more psychologically plausible foundations.

Its central theme revolves around the study of the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and their consequences for market prices. Hence, it challenges the old notions of homo economicus and rational man.

Although there should have been no doubt, we now know unequivocally and scientifically that it is not only rationality that motivates or guides people’s economic decisions and that the role of the biological brain and its psychological partner, the mind, are critical factors in any economic decision.

A good example of this relatively new economic notion and how it has grasped the truth about the “real irrational market” is the 2008 US financial bubble that resulted from the subprime mortgage disaster and perhaps caused the on-going global economic crisis that has plagued much of the world since then. The best literature to point to in order to highlight the causes of this crisis stirring the old canon is perhaps the highly critical paper known as the Dalhem paper.

The paper clearly demonstrates how economists had been predicting outcomes and formulating policies based on the notion of homo economicus and the rationality of market agents while the 2008 crisis took place right under their nose, leading to an utter failure, neither in warning governments nor in averting the looming crisis.

This crisis was [and still is] overtly analyzed in a manner based on the implicit assumption that market participants [agents] function rationally at all [or at least at most] times when making choices. Yet, contrary to this notion, the market participants [agents] in the real world have been behaving irrationally [to the extent that it resembles a self-destructive pattern] when it comes to the real-world market regarding mortgages. Participants were buying and buying even though they knew they couldn’t afford it!

None of the mainstream economists cared to check on the notions of behavioral economics and study the real-time reactions of market participants [agents] and how their assumed ‘rationality’ is pretty much unreliable.

It is not enough to put the existing model to one side, observing that one needs “exceptional measures for exceptional times”. What is needed are models capable of envisaging such “exceptional times,as David Colander et al. stated in 2009.

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Since the purpose of this article is neither to discuss the shortcomings of homo economicus nor to suggest alternatives to it, one of the factors that make homo economicus impractical is relevant to the central theme of this article.

As it happens, one of the dynamics that make homo economics a failed attempt to formulate the ‘Golden Economic Theory’ is rooted in the nature of our world itself. We live in a continuously changing world, and the behaviors of yesterday are often not good for today; they are either obsolete or futile.

Hruy Tsegaye is the co-founder and product manager of iCog Labs Software Consultancy.

Contributed by Hruy Tsegaye Berehe

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