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The Psychology in Economics

I was in a poker game last night when a conversation with a Libertarian broke out — you do meet the most interesting people at poker tables. He made some crack about how the only sensible thing these days was to hoard gold and that essentially all his expendable cash was going into bullion.

“Ah,” I thought. “A ‘gold-bug’.” These guys are usually fans of Rand Paul, cleave to the Austrian School of economics (e.g., Hayek and Mises), hate Keynes and despise Paul Krugman.

Turned out, during a break, that I was right on all counts — and he was wrong on all economic issues. The reasons why he/Paul/Hayek are wrong and Keynes/Krugman are right has everything to do with psychology for without the psychological elements, economics becomes an empty play of mathematical models with no hope of describing what actually goes on. Here’s why:

1. Money v. Currency: Libertarians like to challenge folks on the left by asking, “Do you even know the difference between money and currency?” It’s a line that goes back to the Austrians (in particular Mises) and, since most liberals don’t, they immediately find themselves on the defensive. So, of course, these were the first words out of my new friend’s mouth. The difference, in case you care, is that money is supposed to be abstract and unreal while currency is some physical entity (gold or paper) that people use in exchanges for products. Since some physical currencies (like gold) have what is called “intrinsic value” (people like it independent of any government) they are to be preferred over other physical currencies (paper) where there is no “intrinsic” value but only that provided by the government that printed it. Since Libertarians think the US economy is doomed and the dollar headed into the crapper any day now they hate that the government prints money, hate that the Fed controls interest rates and the money supply — in fact, they hate the Fed and would, if they had their way, do away with it in a New York minute and return to the gold standard.

Okay, so what’s wrong with this? Well, almost everything because it neglects psychological factors. Nothing has intrinsic value. No object, be it a naturally occurring one like a mineral or a manufactured one like a Euro, has any value other than what people endow it with. Gold is convenient because of various properties including that there’s just the right amount of it around and, well, it is kinda pretty. But in the end, all value is psychological. People need to believe that others believe in the currency in use, as the recent bitcoin fuss shows. Psychologically, you don’t want to diss the dollar; you want to prop up belief. Fortunately, those who embrace the US dollar and respect the Fed have been winning this argument. The US dollar is still the world’s currency and there’s no sign of the run-away inflation and soaring interest rates the Austrians predicted. This is good for everyone, including my friend who, in case he hasn’t noticed, has had his portfolio thumped recently as gold has taken a nose dive.

2. The Silent Hand: After I bamboozled him with this stuff he shifted to the next Paulist talking point: the market is controlled by the silent hand which will ensure that, left unencumbered by nasty governments sticking their noses in, things will go just fine. This argument is based on a simple assumption: human beings are rational decision-makers and so long as all bartering and exchanges are made using principles of maximizing self-interest (what the Austrians call “purposeful actions”) the system will function and the economy will grow. This argument is a fascinating one and it gets very complicated very quickly as modelers developed complex mathematical systems to try to explain how this happens and why it works best when the system is left to its own devices — i.e., the “free market.”

We don’t need to look at the models to know that this position is embraced by capitalists. We also don’t need to look at the models to know that it is wrong. Really wrong, utterly deadly, fundamentally wrong. As wrong as any model can be and for the simplest of reasons. The core assumption is wrong. People are not rational and they do not make decisions based on self-interest. When your core assumption is wrong the whole edifice collapses — like the economy did in ‘08 because nonrational decision-making was rampant. That little shocker even brought Greenspan to his senses as he admitted that he had vastly over-estimated the role of rationality.

In recent decades psychologists Herb Simon and Daniel Kahneman have won the Nobel Prize in Economics. Simon showed that it just wasn’t possible to make rational choices in real-world settings because there were too many factors to unpack. Instead, people try to narrow the scope and make “bounded rational” decisions. But, of course, these too will ultimately be arational because the decisions about what not to include cannot be made rationally for the very same reasons: the system is too complex to be handled. Left unfettered the system will collapse.

Kahneman showed (along with Amos Tversky, his long-time collaborator, who died in 1996) that human decision-making is driven by factors that call on emotions, cognitive biases, misplaced values, fears and other messy things and that no one makes anything like rational choices. A simple example: money is gain/loss asymmetric. That is, a loss of some amount (say $1000) hurts more than an equivalent gain feels good. People are mostly risk-averse and, hence, decision-making will be biased. Kahneman and Tversky found dozens of these kinds of biases, all of which corrupt rational decision-making.

In recent years economists have begun embracing Behavioral Economics where these kinds of psychological elements are an integral part of the field. Slowly they are beginning to make sense of economic systems and getting a better understanding of how markets really work. Libertarians hate these guys because their research shows just how naked the Austrian economic emperors are.

3. Debt: Thwarted again, he shifted to the next topic: “We are so far in debt as a nation that future generations will be devastated because they will have to pay it off.” This, of course, is nonsense. Debt isn’t some raw figure; debt has to be seen in the context of the overall economy, the GDP. Homeowners and businesses incur debt in the form of mortgages or loans. But these debts aren’t a problem so long as the value of the house or the business exceeds that of the debt. The government will “pay off the trillions” of debt like a business will “pay off” the loans — and, no, your children won’t pay it in any form other than normal taxation. In fact, you can continue to refinance your house and stay in debt forever just like the government can keep borrowing and stay in debt forever. And when interest rates are low this is precisely what should be done. Ironically, Austrians who cling to their old models show how prevalent nonrational thinking is.

For a time the Paulists were citing a research paper by economists Reinhart and Rogoff that seemed to show that if the debt got too high, specifically if it reached 90% of the GDP, then the economy would falter. This infamous paper was found (by a graduate student of all people) to have basic flaws in it, including a failure to include all the data from recent analyses. Put the data back and, guess what? No crashing or burning of the economy. It is true that growth slows somewhat as debt closes in on equalling the GDP but this slowing is a horse of a very different color from economic collapse.

4. Deficits: Okay, he realized he wasn’t going to win the debt game so he shifted to deficits. “Spending has to be cut. It’s the only way to reduce the deficit.” Well, of course, that’s just silly. You can cut the deficit by increasing revenues but that means having a progressive tax code and we know where Libertarians are on that subject. “Actually,” I said in my most professorial voice, “the best way to reduce the deficit is to make dramatic increases in it by shoveling money at the economy.” When the color returned to his face I said, “The reason the recovery has been slow is because the stimulus package was too small and not enough went to big projects to improve the infrastructure. Moreover, if you want to boost things right now, increase the minimum wage and extend unemployment insurance. In a recession, austerity kills economies.”

His eyes narrowed and he looked at me … “You’re a Keynesean.”

“Of course,” I said. “Keynes was the first economist to think psychologically.”

“You believe that crap? That stuff that Krugman writes?”

“Krugman is, in the words of the Berkeley economist Brad DeLong, ‘the man who is always right.’”

“I think we need to go back to the poker table,” he said.

And we did and I was glad to because he wasn’t a very good poker player either.

Reader Comments (2)

On point 2, you've built a straw man. Austrian theory has never relied on rationality in the optimal sense you describe, but only in the sense of achieving a desired end. In Human Action (p. 19) von Mises writes "Human action is necessarily always rational. The term 'rational action' is therefore pleonastic and must be rejected as such. When applied to the ultimate ends of action, the terms rational and irrational are inappropriate and meaningless. The ultimate end of action is always the satisfaction of some desires of the acting man."
The theory encapsulates errors in human judgment as well as altruistic action, but despite this, free actors are still best placed to grow an economy.
This old straw man argument alone, on such a critical principle, suggests that you have not read Austrian economics from its source (maybe just poker tables?), or have rejected its principles for other reasons not stated. Unfortunately that means everything else you say in the article needs to be taken with a grain of salt.
To everyone else I suggest read from the founders of Austrian theory and draw your own conclusions.

October 14, 2014 | Unregistered CommenterJohn

Just wanted to add, looking through your site, it really looks great and I may even return to read more. Sorry if I came across a bit gruff in my comment, but its disheartening to see theory with a number of merits (albeit never perfect) shot down on false assumptions about it. I can see where many proponents of Austrian theory are uninformed and can be easily countered (and likewise from other economic schools). I just suggest you should hold a higher ground if making it a public target. All the best.

October 14, 2014 | Unregistered CommenterJohn

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