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.