Behavioral economics

Over the past months during the current economic recession and financial crisis, there has developed a published opinion as if so-called behavioral economics could explain the crisis. Behavioral economics emanates from observations in economic and game theoretic experiments that human subjects do not behave rationally, but are clearly bounded in their reasoning about decisions. Subjects are now routinely put under MRI scans to see which parts of the brain are used in which decision situations.

The main problem with behavioral economics is that it is staunchly methodological individualistic; the center of decision-making remains the singular individual. I think that consequently it cannot satisfactorily explain the economic world and certainly not the current financial crisis. This crisis has its origin in a failure of trust between contracting parties in the financial sector of the main economies; as argued before, it can be called a true trust crisis. Trust is fundamentally an interpersonal phenomenon and should be explained through sufficiently developed social theories. These theories cannot longer be founded on methodological individualistic arguments, but should rather be based on more interactive and social considerations.

Methodological individualism has as its singular strength that it is particularly open to successful mathematical and statistical modeling. As such economics is the outcome of a long history of methodological individualistic modeling. Its world-view is essentially alien to regular human interaction and more suited to model behavior of decision makers with autistic tendencies as recently pointed out by Tyler Cowen in his discussion of academics. In his new book Cowen takes that a step further and promotes the idea that we essentially should become more autistic, thereby essentially arguing that the world should actually adapt to economic theory rather than the reverse. It fits with a long history of economists trying to fit the world to their limited understanding and promoting individualism as a "good" behavioral mode, thus denying the fundamental sociality of the human condition.

I think that economics should rather adapt to understand the world better and at least soften-up on the issue of methodological individualism. Recently, Paul Romer presented an innovative way to look at history from such a more social perspective. However, to be successful at looking at the economy from such a social perspective, economists need to abandon their trusted methodologies. They should recognize the utter complexity of the economy and allow the use of a wide range of techniques to be used to understand it. This not only implies the use of mathematical analytical modeling, large-scale measurement of economic activities, and simple experimentation in the laboratory, but also the use of simulation models and statistical approximations as used in theoretical physics. As it stands now, economics remains rather irrelevant and marginal a science.

A dismal "science"

Recently, Steve Keen added his voice to a growing list of objectors to neo-classical economics as we know it in view of the current financial trust crisis. The common thread in these comments is that what is taught as principles of economics in class rooms around the world is plainly wrong and even misleading about the functioning of our globalized economy. Some argue that economics, in fact, still functions as physics did in the days before Copernicus; the "dismal science" is essentially not scientific at all yet.

The consequences of this misunderstanding of our economic world are severe. Neo-classical principles such as the efficient market hypothesis are plainly untrue and dangerous, since these simplified views of the world allow greed and fraudulent behavior to undermine the required trust to sustain the gains generated through economic networks. The consequences of the collapse of trust have been shown to be extremely severe in our globalized network economy. Credit markets have frozen and people responded by reducing spending, thus creating a severe recession that might still turn into a worldwide depression.

Therefore, a new set of economic principles has to be proposed and should replace the currently outdated 19th century Marshallian principles that economists teach in introductory economics courses. This new set of 21st century principles should be founded on a network or relational perspective of the globalized economy and contain such principles as the tragedy of the commons, principal-agent theory, information economics, in particular Akerlof's lemons market, and Adam Smith's theory of economic development through the deepening of the social division of labor. The common thread is that we depend on each other in our contemporary economy and that our economic plight is acollective one. Competition is just icing on the cake, but the foundation is and remains interdependency of the economic actors.

Awful shocks II

The 2007-08 financial crisis should have major consequences for economics and economic theory in particular. Propelled by this fierce crisis, economists should now finally see that they have propagated a completely wrong perspective on the economy and society around us.

Economists teach that the world is essentially open and that markets absorb all information that is relevant to the commodities traded in those markets. Furthermore, economic theories are not concerned with such trivialities as trust and the costs of maintaining a trustworthy institutional setting for markets. These theories assume away all costs of making transactions and the institutions to support markets. How wrong these theories are!!

The financial crisis shows that maintaining trust is of supreme importance and that without sufficient trust there is simply no trade possible. The freezing of the credit market and the collapse of the stock markets worldwide show this clearly.

So, what can economists contribute here more than some silly platitudes like the ones that I have stated them in the previous lines? Not much, to be honest. we need a new economics. As the depression-era of the 1930s brought us the Keynesian revolution, we hopefully will see a major adjustment of economic theorizing in response to the current crisis. We really need it...

A new economic paradigm should emerge and address the main questions of what exactly (economic) trust is and how we support it. This should lead to an institutional theory of economic behavior that goes beyond the limiting market view and individual selfishness as the almighty guide in economic decision making.

Justinian's Flea

I recently read William Rosen's Justinian's Flea, an account of the plague that devastated the Byzantine Empire around 540-542 CE.
Rosen mainly argues that in the west, the reduced populations in northern Europe forced a revolution in farming techniques. More advanced techniques were necessary after the reduction of the availability of cheap labor and secured the survival of the Germanic tribes in Europe. Consequently a feudal society emerged from the plague and defined the developments throughout the middle ages until the second visit of Y. Pestis in 1347-48, which again changed the cultural, economic and political landscape of Europe.
My interpretation is that Justinian’s plague allowed the Germanic tribes to settle permanently in various locations in western Europe, including Italy, and to establish new societies based on Christianity and a feudal economic hierarchy. Indeed, it is only after Justinian’s plague that the tribal movements stopped and these tribes settled in the areas that they had conquered up till that time. It is in these areas that they established their feudal societies and built their Gothic churches.

Awful shocks...

The ultimate shock that a society, and therefore an economy, endures is one in which a very large part of that society is affected. We talk here about all-encompassing wars, like WW I and WW II in Europe or the Civil War in the United States. But the most striking examples of such ultimate shocks are pandemics. And the worst of these were the two plague pandemics in 542-545 and 1347-1348. Of course, the disease swept various geographic areas after those two visits on a regular basis, but never as profoundly as in those two occasions.

The culprit of these two plague pandemics is the bacillus Y. Pestis. It is the ultimate killing machine when unleashed on its victims. And on both occasions the bacillus migrated from rodents to humans through fleas. The effects were devastating and in both cases 1/3 to 1/2 of the human population was wiped out, in particular in cities and other densely populated areas. In both cases the effects on the economy were profound and caused a significant change in history.

In my next postings I will try to sketch the consequences of the visits of Y. Pestis to medieval Europe. Numerous new accounts have recently popped up and there seems an increase in the study of these consequences in the economic history literature.

Trust through networks; networks through trust

Recently there has been a small surge in the economics literature addressing the role of trust in the economy. Experiments have shown that trust is extremely important for understanding economic processes. Trust does not fit very well with the traditional concept of "homo economicus": Rational behavior is not trusting. The building and confirmation of trust usually requires sacrifices of resources, contradicting the utility and profit maximizing hypotheses of the homo economicus.

The Scientific American recently posted an article that looks at the evidence for trusting behavior from behavioral economics, in particular trust experiments and brain scan evidence from neuro-economic experiments.

I want to add my own two cents worth to this. First, trust building is directly related to the functioning of socio-economic networks. The better the functioning of these networks and the denser these networks, the better the development and building of trust. This in turn forms the foundation for a better functioning economy. (A neglected aspect in traditional neo-classical economics.)

On the other hand, network building is firmly founded on the presence of trust and behavioral norms of trusting behavior. The higher the level of trust in the society, the better one is able to build and maintain social networks.

This two-way street between trust building and network building lies at the foundation of my research on networks. It now seems that more and more evidence confirms the justification of these and similar theories of network formation. Here I also refer to the recent work of Markus Mobius and his co-authors.

Economics and markets

I will use this blog to post random thoughts about economics and economic theory. In my postings I intend to promote a relational perspective on the economy.

I do not think that economics is a very mature science and has a very difficult subject of study. Economists in general, on the other hand, have strong beliefs that they know a lot about the functioning of the economy and point to the relatively recent successes of the market paradigm in our globalizing world economy. As a consequence in the teaching of economics we promote a view of a unified economic theory based on the market as the main allocation mechanism. But what is exactly a market?

In economic theory a market is a very restricted and precisely defined mechanism based on the assignment of a unique market price to a single commodity that reflects its true "value". This does not fit very well with reality. In practice, the notion of a "market" refers to a wide variety of economic concepts such as one's clients, a broad geographical area, a place where demand and supply meet in the broadest terms, and of course a farmers' market.

Economists pretend to understand this wide variety of mechanisms and networks with the single instrument of the theoretical market concept. This seems very pretentious. We should be more humble and accept that our science is still very immature. We should also allow the development and discussion of multiple theories and models for similar phenomena to take place in our journals. At the moment these journals are strictly closed for any contribution that deviates too much from the accepted paradigm. This stifles the development of the economics science.

The EconNet web site and this blog try to promote alternative views of economic phenomena that go beyond the traditional paradigm of neo-classical market theory.