It’s no secret that some of the fundamental assumptions of economic theory are faulty.
Specifically, the primary model in economics is that individuals invariably take actions which make good economic sense. The mythical “Homo economicus” (“Economic Man”) is motivated at all times:
- To purchase goods and services that have lower cost;
- To create goods and services that they can sell at higher price;
- To minimise the amount of effort that they have to expend to create these goods and services.
Real world people, of course, deviate from this model in numerous ways. Lots of other things motivate us, beyond purely economic concerns.
Indeed, we can arrange human decisions on a two-by-two matrix:
- On one dimension, decisions vary between economic motivations and non-economic movitations;
- On the other dimension, decisions vary between rational and irrational.
Theories of classical economics take their lead from just one of the resulting four fields of life – the field of economic motivations that are pursued rationally. But what impact do the other three fields have on overall economic questions, such as booms and busts, inflation, employment, savings, and inequality?
Many classicial economists give the strong impression that these other three fields have limited impact – somehow their effects average out, or can be discounted. More recently, the rise of behavioural economics has challenged this conclusion, by increasingly providing evidence and analysis of factors such as:
- Irrational biases in human decision making;
- Herd mentality;
- Limits of information;
- The motivational importance of factors other than economic ones.
The best account I’ve encountered of this whole topic is the book “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism“.
This book was authored last year by two eminent economists, George A. Akerlof and Robert J. Shiller. Their phrase “Animal Spirits” is taken from Keynes – from a part of the thinking of Keynes that, they believe, has been too often neglected (even by people who describe themselves as followers of Keynes):
The markets are moved by animal spirits, and not by reason
Akerlof and Shiller provide five chapters that explain each of five important contributors to “animal spirits”:
- Confidence and Its Multipliers
- Corruption and Bad Faith
- Money Illusion
These explanations interweave many accounts of economic episodes over the decades, adding to the plausibility of the fact that these factors matter a great deal.
Next, Akerlof and Shiller show how considerations of these “animal spirits” provide deeper insight into each of eight key questions of economic theory:
- Why Do Economies Fall into Depression?
- Why Do Central Bankers Have Power over the Economy (Insofar as They Do)?
- Why Are There People Who Cannot Find a Job?
- Why Is There a Trade-off between Inflation and Unemployment in the Long Run?
- Why Is Saving for the Future So Arbitrary?
- Why Are Financial Prices and Corporate Investments So Volatile?
- Why Do Real Estate Markets Go through Cycles?
- Why Is There Special Poverty among Minorities?
To my mind, the analysis is devastating: any serious discussion of eonomics needs to take account of these findings.
Footnote: Amazon.com contains a whole series of nasty and devious reviews of this book. Don’t be misled by them! The motivations of the people writing these reviews would be a worthy subject for an analysis in its own right. There are other kinds of “animal spirits” afoot here.