Although a few years old now the mini-documentary below is very good and features many notable economists and economic thinkers. They basically look at the issue of financial stability, or the lack thereof, and discuss what is at the core of the problem. It includes Joseph Stiglitz, Gillian Tett, David Tuckett, Stephen Kinsella, John Kay, David Weinstein, Steve Keen and Dirk Bezemer. I have used this post to try and bring some reality to a lot of prescribed economics courses at high school level.
With the COVID crisis economists have got in wrong in many of their predictions. In New Zealand they stated that house prices would fall by 30%, unemployment would rise to between 15% to 30% and the downturn in NZ would be a lot worse than the GFC in 2008. Auckland house prices have risen by 17% since the outbreak, Unemployment is only at 4.7% and GDP growth expanded 1.6% in the March quarter. There is a very good podcast from Radio New Zealand’s Media Watch programme in which they discuss the problems of economists’ forecasts. Furthermore economists have long proven to be bad at predicting recessions.
- A study by the IMF in 2018 looked at 153 recessions in 63 countries between 1992 and 2014 and found the vast bulk of them came as a surprise to economists.
- The Queen famously asked why nobody noticed the 2008 Global Economic Crisis coming.
- In his acceptance speech for the Nobel prize for economics, Friedrich Hayek said economists’ tendency to predict things with the certainty and language of science was misleading and “may have deplorable effects”.
The economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.
According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:
- confidence in ones’ abilities,
- moral self-esteem,
- hope and anxiety reduction,
- social identity,
- political ideology
- religious faith.
Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.
If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.
The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.
Strategic ignorance is when a believer avoids information offering conflicting evidence.
Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.
Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.
People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.
Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.
“To err is human; so is the failure to admit it” – The Economist June 10th 2017
“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16