Anyone who pays even the slightest attention to the financial news asks themselves this question. We see them on TV and when some unfortunate questions their opinion they are given the raised eyebrow which is shorthand for “you really are fortunate I talk to you”. Anyone questioning these guys with less than a Phd. they dismiss as idiots. There is no need to go into the numerous ways the various economists have gotten it so wrong for so long. So I will just get right down to why they have been so wrong for so long and why economics is not a science.
Economists just like real scientists can show you a bunch of graphs and equations. But unlike those who base their theories on quantifiable and measureable tests that can be repeated and used to predict the outcome of a similar experiment the economist cannot. If you cannot predict the outcome of an experiment based on previous results then what you have is not a science. What you have is a theory and a flawed one. It’s really that simple and any science major will tell you that. If you cannot set up an experiment and predict the result then the experiment is fundamentally flawed or your measurements are wrong. If you cannot conduct a single experiment and predict the results then you are not a scientist.
So why are they wrong all the time? The answer is remarkably simple. They base their “science” on the notion that the consumer is a rational being and therefore the markets are a place where eventually price discovery and money will flow in a rational manner. The whole premise that the average human can be measured is simply wrong and I can prove it.
ECONOMISTS think of the average consumer as a rational individual who will look for the best deal or in some way balance quality and cheap to suit their lifestyle or needs. They think that rational comes into play with the way we conduct business or simply consume and nothing could be further from the truth.
There is a new wave of economic theory gaining some ground over the last few decades. It’s been given the title of “behavioral economics”. I like to think of it as bologna economics because it likes to take little pieces of meat from everywhere and try and make something pleasant out of it.
Over the last 30 odd years these new economists have tried to figure out why classic economists like Krugman and Bernanke can be so wrong when they follow the text books to the letter. They are starting to amass enough data to say the human being is anything but rational or at least we don't have enough understanding of human behavior yet.
“We’re starting to understand a lot more about people’s behaviour,” says Pete Lunn, a behavioural economist with the ESRI and author of Basic Instincts .
“We’re beginning to see that it’s not the way we long assumed it was, particularly not the way professional economists assumed it was.” This has implications for how politicians and economists regulate and model future behaviour, but also for how we manage our own consumption. Some of the insights coming from behavioral economics have been known intuitively by marketeers and advertisers for decades.
We Gold bugs and Silver bugs in our smug superiority like to think of everyone else as sheep and this is a huge mistake in our thinking. We are not taking into account that we may be just a different breed of sheep. We too like to follow the crowd. We too don’t like to break away from the pack. We too tend to buy what we know or are advised to buy. We too tend to put all our eggs in one basket. When everyone puts all their eggs in the same basket we get a bubble. So far we have avoided that fate.
However, even the marketing guys underestimated just quite how unpredcatable we actually were.
Pete Lunn is filled with examples.
“If you offer people a cash discount for paying in cash instead of plastic, a certain proportion of people will pay cash and get the discount,” he says.
“However, if you change it so that it’s exactly the same situation but you call it a ‘credit card surcharge’ suddenly the proportion of people who do it will radically alter. Very few people will be willing to pay the surcharge and they will put in the effort and will pay in cash instead. But it’s basically the same decision.”
Lunn offers another example: “If you set up two products in a range – product A and product B – and A is cheaper than B, you usually find most people are buying the cheaper product but a small number are buying the more expensive product. It’s maybe a 70/30 split. However, if you introduce product C – a more expensive product again – suddenly more people will buy product B over A. Instead of 70/30 for A over B, it could be 70/30 for B over A. It’s the same decision but it’s framed differently.”
It’s all in way it’s framed and Lunn calls these subtle differences “framing effects” and he is aware of about 70 of these examples. What the Marketing guys know instinctively classical economists are not willing to acknowledge in their equations. How can they?
Without getting bogged down in jargon that every group of people create first as shorthand and then to lock outsiders out of conversations it boils down to this. Most of the decisions we make on a daily basis are actually shortcuts. What we do is apply the outcome from a previous situation to an existing one. In that we don’t get bogged down processing every single decision we have to make by analyzing it over and over. It also means a good marketing guy or scam artist can leverage that to trick us.
In short when a consumer is faced with a decision they apply the processing from a previous decision. Therefore the typical consumer uses a rule of thumb to arrive at an answer. Lunn would call these “Heuristics”
“Following these heuristics is not an entirely irrational thing to do,” explains Liam Delaney, an economist from the Geary Institute in UCD, who is currently spending a year at the Woodrow Wilson School in Princeton, the Mecca for behavioural economists.
“I still catch myself making the kinds of dumb decisions I read about every day,” says Lunn. “But people use the same decision making processes for the big stuff, and that’s where it’s more worrying. Does it matter if people are losing a few cents on beans every week? Probably not. Does it matter if they’re taking up the wrong pension, or taking up no pension at all? Yes, it does. Does it matter if they’re buying overpriced houses because everyone else is doing it? Yes it does.”
Here is where we are all sheep whether we admit it or not. These behavioral economists have concluded that given a choice we will opt for the default choice. Much the same way as when you are presented with the shareholders voting proxy you will invariably not send it in and so your vote will be aligned with the current board members wishes. When you are given the opt in by default but have to make an effort to opt out invariably the default wins.
There are a lot of politicians paying these guys for advice and they will be using these tactics to shape and bend policy to their wishes by default. Obama for one takes advice from behavioral experts as does Prime Minister Cameron in the UK. 2012 is the date set for important personal decisions on pensions in the UK. The default is to opt in.
Apparently behavioral economists helped Obama frame the current policy it in such a way that encouraged spending over saving.
On top of all that we have the Spam sandwich of economics in the form of Neuroeconomics.
This is the latest kid on the block and very early stage studies have been conducted. These guys are hooking us sheep up to measure the reactions in the brain as we make decisions and as we are presented with products. The more we look at ourselves and understand ourselves we become easier to push and nudge in the desired direction. Once we understand how all these little pieces work together then it becomes easier and easier to pacify us and round us up into our pens in the evening and cubicles in the morning.
The simple little credit card surcharge versus cash discount scenarios illustrates how seemingly irrational we truly are. However, what appears to be irrational is simply us taking mental shortcuts but Bernanke and company will not take this information on board simply because he is as stuck in his thinking as we are in ours. We will have to invent a whole new math to quantify emotions and decision shortcuts to truly bend economics to our will.