How Mainstream Economic Theories Regularly Miss The Mark

If what they say is true, that a bad workman always blames his tools, then it would’t be a stretch to assume that it’s a bad economist who always blames the subjects of his study. Such an assumption might be tentative of course, but it’s only fair: Assuming, after all, is what mainstream economists do best, and all too frequently.

The cornerstone of mainstream economics is that the we are all rational actors. Perfectly logical at all times, programmed by birth to optimise and maximise our own interests. We are assumed to be purely analytical agents, governed exclusively by predicable forces, living linear, absolutely efficient lives, solely focused on increasing our gains.

Wouldn’t it be nice if that were actually the case? Hypothetically speaking, if we were all really part of that new species they invented, “homo economicus”, life would be so much easier. Nobody would smoke anymore, drug abuse would be unheard of, gambling too, we wouldn’t suffer hangovers, obesity would merely be an extreme theoretical construct, and of course, I would never have spent nearly two months salary on those obscenely torturous heels that I knew I couldn’t walk on, but bought anyway.

Perhaps it was the field of theoretical mathematics, or maybe physics that started it all: This singular monomaniacal obsession with elegant solutions to complex problems. For centuries, have our best and brightest had their efforts focused on simplicity. They have since time immemorial struggled to tame reality to fit a concise equation, to make our experience of the world seem manageable and orderly. And then economists thought they could do it too. Problem is, they deal not in numbers and triangles and electrons. Their business is people. And those pesky humans just flat out refuse to be behave themselves and respect the terms and conditions of all those theoretical assumptions and arbitrary rules. Speaking hypothetically, it seems, just simply doesn’t quite cut it when trying to describe real life.

Castles in the Sand

Human judgement and decision-making is de facto imperfect. A myriad of cognitive biases make sure that not one of us will ever live up to the economists’ expectations.

The mainstream economic fantasy that paints the market as an elementary newtonian system, driven by actions and equal and opposite reactions, all toiling away to achieve the mythical, ever elusive equilibrium, has been the breeding ground for so many of the theories we have seen brutally debunked in the last century. But it has gone beyond pointless, yet harmless, theorising and philosophising; it has proven to be dangerous: Once you really believe you can predict the future, the temptation to control it isn’t too far away.

And that is when things go horribly wrong. Applying blanket policies on heterogeneous groups, trying to force behaviours that contradict man’s evolutionary traits, positive or otherwise, enforcing one-size-fits-all rules to tame the inherent unpredictability of human nature, it’s all basically tantamount to hubris. As a direct result, we have seen the intended and unintended consequences of these grand designs wreak havoc with the lives of law abiding citizens, entire societies splinter apart and once-great nations razed to the ground. Toxic ideas, cultivated in this environment of delusional omniscience and absolute certainty, fostered by reckless arrogance, soon metastasised to politics and became the law of the land: Central planning, state monopolies, interventionism, they are all a thorny rose by any other name.

It has been stated before, by people much smarter than the writer of this article, that economics should be practised as a discipline subordinate to psychology. Our markets are so intricate, so astoundingly complex and the forces that really drive them are deeply entangled and interconnected, that much like the human brain itself, no sane man would dare think that simply changing just one thing, by fixing this part or cutting out that little bit right there, would suffice to steer them at will, to correct them and to cure them of all their perceived ailments. That was the principle behind the lobotomy too, and we all know how many satisfied customers that left us with.

After years and years of failed policies and what seems as an unending procession of cloned gurus and experts claiming to hold all the answers and some near-psychic gift to predict the future, all we ever hear when their best laid plans inevitably go sideways is that human irrationality is to blame. It’s always us, not them. So then they add desperate amendments and conditions and caveats to their theories, trying to stop the Titanic from sinking by plugging the iceberg hole with their fingers. When it finally sinks, we are to blame again. “Well, we didn’t account for people just jumping off the boat, of course. Their survival chances would have been so much better if they stayed behind and helped us plug the hole. It was pure human irrationality at play here.”

As a rule, they’re not right about a lot of things. But they’re right about this. It is indeed pure human irrationality at play here. And there. And everywhere.

Theory vs Practice: 0-1

We buy high and sell low, we regularly throw good money after bad, cause “this time its different”, we believe in lucky streaks and we really think we can beat the roulette because we’ve been watching it closely for a while now and we know what it’s gonna do next. We make bad decisions, they cost us money and we are fooled by our flawed perceptions of reality, and it is indeed annoying. But at least it’s also annoying to the classical economists desperately trying to “civilize” us, so that’s a fair trade off.

Study after study on economic behaviour and decision making, makes one point clear: The choices we regularly make are as irrational as they are unpredictable. There is no shortage of real life examples of how theory and practice often go their separate ways.

In 1979, Kahneman and Tversky came up with Prospect Theory, which won a Nobel prize in 2002, as the coup de grâce or final nail on the coffin of classical utility theory. The main concept is that people value gains and losses differently: Losses hurt more than gains feel good (“Loss aversion”). If one is given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former – even though they represent the exact same economic end result. For example, in classical economic theory, $50 is $50, come rain or sunshine. Therefore, receiving said $50 should be equal to a situation in which you gained $100 and then lost $50. Both scenarios leave you with a net gain of $50. However, prospect theory experiments and research clearly demonstrates that the majority of people chose a single gain of $50 over gaining $100 and then losing $50.

Throwing good money after bad is another good example of how our thinking gets hacked by circumstances. The “Sunk cost fallacy”, as it is better known in polite academic circles, basically describes anyone that ever bought a ticket to a terrible play, knew it was going to be terrible 15 minutes in, yet stayed and suffered through the whole duration anyway. “In for a penny, in for pound” is another way of putting it, and it is basically the petulant refusal to admit defeat and cut one’s losses, just because of an initial investment. Investment decisions are often riddled with it: Buying a stock that clearly proves itself a dud and yet continuing to pour more money into the wishing well, hopelessly chasing after the original amount.

The bandwagon effect is also quite a chubby fly in the ointment of classical theories. Even though the Dutch tulip-mania is the most commonly cited example, in recent years we have a fine selection of bubbles and bursts thereof to demonstrate the surreal results of irrational herd behaviours in the economy. A number of forces, social and psychological, gently nudge us to mimic the behaviour of the larger group and to “go with the flow”, even when the direction of said flow defies our understanding or better judgement: It might be “safety in numbers”, social pressure for conformity or simply a nagging sense of “look at all these people lining up to buy this stuff, they must know something I don’t and surely, they cant all be wrong; I better not miss out on this opportunity”. Whatever the case may be, when enough people join in and the bandwagon reaches critical mass, its spectacular collapse is always quick to follow. The Dotcom madness was brutally illustrative of this: Frantic, contagious buying followed by equally irrational, panic ridden selling, with no regard for the actual value of the traded commodities. The obscenely overvalued dotcom companies of the late 90s were the tulips of our time, and we overvalued them using exactly the same “logic” that allowed a single tulip bulb to be exchanged for 12 acres of farm land in 1636 Holland.

It is no wonder that gambling has been so often associated with investing and trading behaviours. Similar cognitive pitfalls frequently underlie the decision-making processes of both the roulette aficionado and the trader alike. The same primitive, “gut feeling” based thinking, or “gambler’s fallacy” to give it its proper name, that compels otherwise rational people to bet their houses on “red” because it came up “black” 4 times in a row, also underpins an investors’ decision to liquidate a position, because it has gone up in a series of consecutive trading sessions, and thus “had had its run” and is bound to now recede. Neither one is filtering their decisions through principles of causality (the forces that actually govern roulettes or stock performance, versus mere coincidence) or any other form of logical reasoning for that matter, while both are flying in the face of classic economic hypotheses of what a rational actor might and might not do.

If there is any moral in this story, it would probably be the value of humility: Given that the economy consists of so many moving parts, and given that those parts aren’t even obediently mechanical, but irritatingly human and thus persistently inconstant, it is simply foolish to make overarching predictions, and it is practically Icarian to try to tame, control and regulate it.

Therefore, humbly acknowledging that everyone is different, no attempt shall be made to generalise or to mass diagnose and to prescribe our own brand of panacea. Most likely, your best bet might not be to read the next wave of astrological market predictions you’ll get in your very respectable mainstream financial newspaper. Instead, what might be worth your while is to trace your cognitive weaknesses and potential logic gaps, to map your own blind spots: to know thyself, thereby being able to understand and to control your own behaviour and choices. There is no need to predict the future of the entire economy; all one needs to predict is their own reaction, whatever that future brings.

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