Friday, October 31, 2008
David Brooks suggests in a column in the NYT that one of the things the financial meltdown reveals is the inadequacy of economic and social theories based on the assumption that man does actually engage in rational calculation and maximizing self-interest. He cites Alan Greenspan:
As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”
Brooks goes on to argue that the fallacy in the economic models based on rational decision-making is their failure to consider the very first step in the decision-making chain -- our perception of the situation. He continues:
My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking. . . .
And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters. . . .
If you start thinking about our faulty perceptions, the first thing you realize is that markets are not perfectly efficient, people are not always good guardians of their own self-interest and there might be limited circumstances when government could usefully slant the decision-making architecture (see “Nudge” by Thaler and Cass Sunstein for proposals). But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they’re even more likely to filter inconvenient facts.
Over the past couple of years, I have thought that some of the most perceptive work being done in the area of consumer regulation is the application of behaviorial economics. See, e.g., "Consumer Contracts: Behavioral Economics vs. Neoclassical Economics", Oren Bar-Gill & Richard Epstein.
It also strikes me that behaviorial economics could almost be characterized as a personalist approach to economic theory -- trying to figure out how the individual human person actually reacts in the economic market, versus assuming rational self-interest. Does this make sense to any of you law and econ types?