A Paradigm Shift in Economics
Orhan Erdem
“The crisis has in many ways put us in doubt about what we know about the economy.”
Barry Eichengreen, UC Berkeley
In a rare occasion, the 2013 Nobel Memorial Prize for Economic Sciences was shared amongst three people with very diverse views on economics: E.F. Fama, L.P. Hansen and R.J. Shiller. Fama and Hansen are from Chicago, while Shiller is from Yale University. This selection can be considered interesting in two aspects. Foremost, Fama and Shiller work primarily on finance. In other words, these two scholars won the Nobel Prize may infer economics slowly comes to terms with finance. For a long time, economics had turned their back on other sciences, especially finance. Second, the choice of recipients is also interesting as Fama and Shiller advocate diametrically opposite finance theories.
Shiller explained this phenomenon during an interview with the New York Times, in which he states: ‘It’s like having a good friend who is a devout believer in another religion. You can learn a lot from a friend like that, even if you don’t pray in his church.’ (19 October 2013). The selection is, in a sense, an external reflection of a paradigm shift in economics. This is because the global financial crisis, which started in 2007, resulted in a process of reflective questioning of the teachings of both capitalism and modern economics.
The financial crisis had an immense impact on the real economy. As an example, according to the Fed, the total value of household's real estate within the USA was 20.7 trillion dollars in the first quarter of 2007. By the end of 2011, this value dropped by 23% to 15.9 trillion dollars. During this period, economists and economic theories were exposed to harsh criticisms. Along with the failure of economists to predict the upcoming crisis, these criticisms emphasized some theories might in fact have caused or at least contributed to the crisis and, more importantly, none of them has put forth any solutions to it. While Fama represented the conventional view, Shiller stood for the voice of a peripheral paradigm. Hence, when the Nobel Prize in Economics Committee was making their selection, they indirectly pointed out the peripheral paradigm should have more room in economic theory and practice.
After the crisis, the legendary former chairman of the Fed, Alan Greenspan, stated in the US Congress that he was mistaken for so firmly believing in economic theories. The 2008 Nobel Prize in Economics winner Paul Krugman has gone one step further during the annual Lionel Robbins memorial lecture at the London School of Economics in 2009, criticizing economics by stating most work in macroeconomics in the past thirty years has been useless at best and harmful at worst. Over seventy five years earlier, John Maynard Keynes was quite critical about the capitalist system in an article at the Yale Review Magazine: ‘‘The decadent international but individualistic capitalism, in the hands of which we found ourselves after the war (WW1), is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous--and it doesn't deliver the goods. In short, we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed.’’ This paper intends to illustrate the need to respond to this perplexity by considering reforms and revisions of economic theory and also formations and formulations of new economic theories.
The controversies are even more important, as they are primarily centered on hypotheses which form the basis of capitalism. The crisis in 2007 pulled the trigger for this, and the Nobel Prize for Economics that was presented six years later will probably stimulate the debates further. The main concerns of the debates are economic models. While building their models, economists have to make a choice between reality and simplicity. While simple models are easy to figure out and solve, models which are close to reality are difficult to understand and solve.
In this balance, economists predominantly preferred simplicity over reality. For this reason, many of the models used in academic research, claiming to analyze an average person, moved away from reality too much by ignoring the most basic flaws of humans. Keynes (1976) has constantly pointed out psychology is the most important factor which affects the economy. Adam Smith (1759), who is considered the founder of modern economic teaching, states that emotions, feelings, and morality are diverse and essential aspects of human behavior, and thus it is not right for economists to ignore (or worse deny) these. On the contrary, these are attributes and subjects which are worth researching. However, in time economists drifted away from these subjects, opening the doors for incorrect and harmful conclusions. Hence, this article’s primary aim is to argue the economic doctrine, which has largely ignored the human aspect, needs continuous reform. The examination of problematic concepts and various models are at the core of this article. Thus, I form this article around a critical engagement with the Efficient Market Hypothesis (EMH) with its assumption of rational individuals.
The Efficient Market Hypothesis (EMH), which emerged in 1965 when P.Samuelson examined a thesis entitled “Théorie de la spéculation” written in 1900s by Louis Bachelier. The theory was developed and incorporated into the literature of economics and finance by Eugene F. Fama. Fama (1965) defines an efficient market as a market where there are rational profit-maximizers competing and thus the place where the actual price of a security is the correct estimate of its intrinsic value. Thus, EMH can be summarized in two parts:
• There is no free lunch: All the information in the market is incorporated in the asset prices. Hence no investors will be able to use any bit of information to earn money. This does not mean that nobody can earn money. In contrast, they can, but this can be random not by using charts and technical analysis etc.
• The price is right: As all the information in the market is already incorporated in the prices and the people behave rationally, the price of any asset cannot be overvalued or undervalued. Therefore, the asset prices are very close to their intrinsic value and it is not possible to observe asset price bubbles.
Michael Jensen, an Emeritus professor in Harvard, has praised the EMH in 1978: “…there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” While the assertion of “there is no free lunch” has faced many criticisms, it is not the subject of this paper. I would rather like to focus first on, the underlying assumption of rationality, and second the statement that “prices are right”. I will consider each of them separately.
The rationality of individuals can be summarized as the trait of continuously and consistently analyzing all available alternatives and making an informed decision based on this full analysis. For this reason, rationalism has a loose relationship with consistent preferences. Herbert Simon was among the first scholars who objected to the rationality axiom. He was an extraordinary scholar who started his academic life studying politics and continued with studies in public administration. He then wrote several articles on physics and later worked on a wide variety of subjects in organization theory, economics, management, and even psychology. Simon stated human beings were not as rational as economic theory assumed, and it was not possible to accurately predict their responses. He also asserted that people calculate and act on the probabilities and the probable results from their experiences. He framed his idea as “bounded rationality”. According to this concept, when people make a decision among multiple options, they tend to eliminate the various options through irrational criteria and invent short cuts, called heuristics. Simon provides the example of a chess game. During such a game of chess there are approximately 10120 (yes, 120 zeros after 1) options, but people generally only make a choice contemplating three to four moves. According to Simon, the rest of the options are eliminated through somewhat arbitrarily constructed methods. In 1977, Simon spoke about bounded rationality during the annual American Economic Association (AEA), and a year later he was awarded the Nobel Memorial Prize in Economic Sciences. There have been many research projects and experiments regarding the irrational behavior of humans. For example, in one experiment, the psychologist Carter (1999) asked women, which nylon socks they liked out of twelve pairs and why. Some of the popular reasons were the texture, “feeling” and color. However, the socks were all the same. The cause-effect relation of humans is not as rational as economics assumes.
Daniel Kahneman and Amos Tversky became famous with their studies about how humans use heuristics in their decision making. Kahneman and Tversky (1974) confirm Simon`s idea through experiments and show that humans have simpler and more irrational decision mechanisms than economics presumes. However, they went a step further than Simon: Kahneman and Tversky (1979) showed how humans can systematically violate rationality under uncertainty. The article showed the contradictions of the Expected Utility Theorem which explains how humans decide under uncertainty based on rationality. Thus, they formed a new theory. The article, which has been cited approximately 13000 times since its publication in 1979 until 2008, has continued to be cited more than 14000 times from the start of 2008 until September 2013. Thus, the article has received much more traction after the crisis. One example they use:
Which of the following options would you prefer the most?
A. Flipping a coin and getting 200$ if it is heads
B. Getting 100$ without betting
Most of the subjects prefer the guaranteed money (B). However, when you change the bet, the selection proportion changes:
Which of the following options would you prefer the most?
C. Flipping a coin and loosing 200$ if its heads
D. Loosing 100$ without betting
While a rational person who chose B in the first experiment is expected to choose D in the second experiment, they often choose C instead. When you look at the two experiments from the perspective of probability, both of the experiments look the same. Yet in practice, some people prefer gambling in the second experiment, but not in the first. In the literature, this is called Loss Aversion. In other words, humans do not make rational choices when faced with probabilities.
The concept of Anchoring emerged from another experiment by Kahneman (2011): the subjects were asked to turn roulette and then answer a question. Normally the roulette should be able to come up with a number between 1 and 100; however the roulette in this experiment was biased to only come up with the numbers 10 or 65. After the subjects spanned the roulette, they were asked the following question:
“What percentage of countries in Africa are members of the United Nations?”
It is apparent, this question has nothing to do with the roulette. However, while the average estimate of those that got the number 10 was 25 %, the average of those who rolled the number 65 was 45 %. In other words, Kahneman and Tversky show irrelevant things irrationally affect us, when we are making a decision. Another reason why people make irrational decisions is overconfidence. For instance, most people believe that they drive better than the average. (Svenson (1981))
Sunk-cost fallacy is also a type of fallacy that concerns economists. Let’s presume that you are an owner of a company and your company invested $100 million in Tokyo and did not bring a very successful profit. In order to fix the company, you need 50 million TL. But at the same time, there is now another $50 million investment opportunity in London which you think will be equally profitable. Will you spend your 50 million on the factory in Tokyo or in the new investment in İstanbul? Most people would want to recover their first investment. If both companies are equally profitable, why do people not equally think about the new investment in İstanbul? Trying to save the sunk money, is not a rational action. The important thing is to use the 50 million TL in the most profitable way possible. This is just like a movie that you have begun watching for 30 minutes and did not like it but you stay for the next hour so that your money is not wasted. However, that hour of stay will cost you, and hence trying to save your money is useless.
Irrational behavior is commonly seen when the number of choices increases. Iyenger and Lepper (2000) carried out an experiment in two separate stands. In the first stand, people had to choose from 6 jams while in the second stand people had to choose from twenty-four different selections. The subjects could choose how many jams they wanted to taste and were given 1$ discount for the jam they chose to buy. At the end of the experiment, although the second stand attracted more customers, they did not buy any jam. The customers simply could not decide.
Another instance where human beings do not act rational is when they are faced with social effects. Solnick and Hemenway (1998), carried out an experiment in which they asked “Would you like to earn $50.000 where everyone earns $25.000, or would you like to earn $100.000 where everyone earns $250.000?”. Given our previous examples, you may already guess the results: most of the subjects preferred $50.000 rather than $100.000.
The studies mentioned above have all been carried out before the crisis. However, although there have been many arguments opposing the rationality concept, these views did not receive much attention – until the crisis in 2007. Potentially through this crisis, we became aware that certain irrational behaviors of CEOs and governing boards, more generally of both banks and other financial institutions, are not an exception but rather part of human nature. The statement in July 2007 by Citibank CEO Chuck Price, regarding the recklessly given loans, is sadly a nice phrasing of herd psychology: “as long as the music is playing, you’ve got to get up and dance.”
It is important to add the above-mentioned studies do not prove that human beings are irrational all the time, but merely show that human beings sometimes act irrationally. The presumption human beings are rational is hence a mistake.
Krugman (2009) stated EMH was one of the most important reasons of the crisis: “The belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history.” The hypothesis in question states the prices are always right and it is not possible to observe a bubble in asset prices. Although this idea often appears in theory, its deficiencies have been shown and emphasized several times in practice.
When talking about the efficient market, Fama sees a price as the best prediction for value of any good. As an example, the income valuation or discounted cash flow method discounts the future profits of a firm including a risk premium. Shiller, who shared the 2013 Nobel Prize in Economics with Fama, made a striking study regarding the subject and put forth counter-evidence to Fama’s theories. In his article, Shiller (1981) calculates the present values of S&P 500’s stocks and compares them with the real prices of stocks and shows that the prices were five to thirteen times more volatile than what EMH asserted. Shiller's perspective regarding the subject is very clear: "The efficient-market hypothesis is the most remarkable error in the history of economic theory."
Despite everything, this phenomenon should not frighten us. Mathematician Mandelbrot contemplates on the situation of the discipline: “Financial economics, as a discipline, is where Chemistry was in the 16th century: a messy compendium of proven know-how, misty folk wisdom, and unexamined assumptions and grandiose speculation.” Considering that the science of finance and economics emerged only a few centuries ago, there is much more to research. Economists have already commenced this endeavor of new theory development. The most prominent of these are probably Behavioral Economics and the Adaptive Markets Hypothesis. The common ground of both is to integrate psychology into the theory. Individuals are not assumed to be fully rational and do make mistakes.
The aim of this article was to point out some imperfections of economic theories and to contemplate on the paradigm shift which is slowly emerging. We suggested these points:
1. Humans do not act as rational as economic theory presumes.
2. The markets do not necessarily work efficiently and may not be in a state of equilibrium. From painful experience of the mortgage crisis we have learned consumption using loans may create bubbles in prices. As a result, when the bubbles burst, humans and institutions that have bought their welfare through credits can be left with huge debts or go bankrupt.
These fundamental mistakes show that although economics is a social science, it has largely ignored the human psychology itself. As Rodrik states “…models neglect the social and cultural roots of people’s preferences and constraints”. Humans are complex creatures who make mistakes and are affected by their environment. Analyzing such a complex creature with simple and mechanic presumptions and simplistic mathematical equations does not seem plausible. Many of the above-mentioned realities regarding human nature were already known and considered by many scholars, especially psychologists. However, they were not deeply included in economic theories. This may be part of a broader problem of isolation and silo thinking of the discipline. Nassim Nicholas Taleb (2007) pointed out that “out of all the disciplines, economics is the most isolated the one who least makes use of other areas.”[5] Akerlof and Shiller (2009) also emphasize macroeconomics must make use of psychology. Through the painful experience of the crisis, it is understood that the economic theory needs to be in contact with other (social) sciences. In the last four to five years, some economists started collaborating with medical doctors, sociologists, and psychologists to write academic papers. This can and should be encouraged and developed further. So, what can be done now? Let us offer these suggestions:
a) Keynes interprets humans as sometimes acting with “animal spirits”, as creations that are not always rational. Hence, economic theories need to be more realistic and human centered. In other words, the new economic teaching and models should emphasize aspects more on human characteristics such as greed, herding behavior, envy, loss aversion etc.
b) Although this stream of research is not new, Behavioral Finance and Behavioral Economics have only become popular after the crisis. Those who study Behavioral Economics begin by accepting that many of the irrationalities mentioned above are very human. For this reason, incorporating psychology into economics looks very promising. However, excluding Kahneman’s “Prospect Theory”, Behavioral economics lacks full- models. This area needs to be addressed more in academic research.
Existing economic theories are not completely false, but they should be developed, improved and complemented in order to adapt to new conjectures and considerations.
Orhan Erdem contact details: email: orhanerdem@gmail.com twitter: https://twitter.com/orhan_erdem
I would like to thank very much to Ali Gümüşay for his great efforts in preparing this article.