Homo Economicus? - Why Economists Need to Revise Their Most Basic Assumption

In 1982, a group of economists conducted a famous experiment, the ultimatum game. In its simplest form, the experiment employs two subjects, which we will call A and B. Person A receives a certain amount of money and has then to offer splitting it with person B. Person A is free to offer person B any amount of money out of the initial sum, which person B is free to accept or decline. If the offer is declined by person B, the two people get nothing. The results of the experiment showed that the lower the offered sum to person B was, the more likely they are to decline the offer. This may sound sensible to most people but it contradicts the assumptions economists have long held. If person B was a rational actor, any offer would make them strictly better off or at least indifferent. Furthermore, if person A was a rational actor too, they would always propose keeping the entire sum. However, when this experiment is conducted, the most successful strategy for person A turns out to be offering a split close to half-and-half. This proposal is the one most likely to be accepted by person B, and thus, the most potentially profitable for A.

Zach Weinersmith (2014) (source)

This experiment challenges the most basic assumption of mainstream economics, namely, that humans are self-seeking rational beings. This opens up notions foreign to the field, such as fairness, socialization or pure irrationality. However, economics were not always like this. From Keyne’s animal spirits to the nowadays despised adaptative expectations, there was a time in which economists seemed to have their feet more firmly on the ground than today. Today’s economics are, to a great extent, the result of taking the self-seeking rational human assumption to the extreme. Through this article we will examine how human irrationality is a real force shaping the economy, explore the dangers of transforming the homo economicus into dogma, and propose a more down-to-earth approach to economics. Although the topic can be analyzed from many different perspectives we will focus here on the issue of economic downturns and the responses to them, something that seems fairly relevant given the current situation of the world economy.

Rationality in Crisis

Although it is clear that the current recession has not been due to a lack of rationality, lots of previous crises do. Furthermore, there is an important and often overlooked factor present in all crises that directly challenges the homo economicus position. Let us have a look first at some irrational forces that continuously threaten economic stability, what Keynes called animal spirits. He put it this way back in the 1936:

“[…] a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” — Keynes, 1997.

Animal spirits are those forces that drive humans to take irrational decisions and that, very often, lead them into disaster. These spirits are nothing more than human emotions, ethics or even lack of thinking. A common denominator to most financial crises is what is called optimism bias. Optimism bias leads people to be excessively optimistic about their beliefs of the current and future trend of the economy. By overemphasizing positive information and overlooking warning sings, it leads us to take irrational decisions (Akerlof, Shiller, 2009). This is often reinforced by pure social pressure and confirmation bias, that molds our beliefs and perceptions in a manner consistent with the socially accepted ones and makes us reject, and even despise, the outcasts. For example, the overemphasis on the data that showed an apparently unstoppable rise in real estate prices and the dismissal of the voices that were warning of a housing bubble, led the world in 2008 to a tremendous recession. The “this-time-is-different” syndrome usually accompanies the optimism bias. Irrationally, by laying aside common-sense and well-founded knowledge, we are led to taking stupid decisions. Still with the 2008 example, by dismissing the common-sense of “what goes up must come down” and the well-founded economic notion that you cannot have high returns and zero risk at the same time, a housing and financial bubble was created.

New York Stock Exchange Market (source)

Forces foreign to the homo economicus realm play a role even after the fire breaks out. As Nobel Prize-winners Akerlof and Shiller have pointed out, narratives are of the uttermost importance (Ibid). A story telling that the economy has been severely hit is a powerful force that leads to an irrational loss of confidence, ultimately self-fulfilling the narrative. Severity is often overestimated, which leads people to restrain consumption and investment and, in turn, makes that severity true (Ibid). 

As a common and painful feature of all recessions, unemployment is something to look at attentively. Although this phenomenon is so common that we all now take it for granted, its existence undermines important economic assumptions about the functioning of the markets. The labor market, as any market, supposedly equates demand and supply through a price that clears it. That is, enterprises demand labor, workers offer it and a wage ensures that at the end of the day there are no vacant posts and no unemployed workers. This is clearly not the case. A rise in unemployment during a recession evidences one thing: labor markets are not functioning “properly”. If markets were perfect, they would simply adjust through changes in wages (downwards evidently) in order to equate the new supply and demand. The truth is, markets suffer of wage rigidity, wages do not react well to changes and remain inefficiently high, thus provoking unemployment. Empirical work shows that wage rigidity is not due to minimum wages or laws, at least not in the majority of cases (Snowdon, Vane & Wynarczyk, 1994). Governments are normally sensible enough to relax labor regulation in times of crisis. A very anti-homo economicus notion, fairness, could be behind a lot of this rigidity. It is important to acknowledge that people have a need to feel fairly treated and that wages are the primary signal through which workers evaluate the fairness of their relationship with the employer. By comparing their wages to others, in and out of the firm, workers adjust their work effort following the “fair day’s work for a fair day’s pay” premise (Akerlof, Yellen, 1990). Enterprises have then a reason to pay wages above the efficient one, since the productivity of its workers and their success in acquiring labor depend on the wages being deemed as fair. There exist other theories, such as the refusal of unemployed workers to offer their workforce at a price that could hinder the position of their employed pairs (Snowdon, Vane & Wynarczyk, 1994). 

It is clear that important forces deviating from the homo-economicus assumption play very relevant roles in provoking malfunctions in financial and labor markets that can ultimately lead to painful recessions. From over-optimism to fairness notions, passing through collective narratives; animal spirits are more material than their name could suggest. Let is examine the painful consequences of thinking that these very real spirits do not exist.

The Dangerous Consequences of Rational Expectations

In November 2008, Queen Elizabeth II asked why almost no economist had been able to predict the financial crisis of that same year. The answer has probably something to do with an inherently flawed assumption: rational expectations. In fact, it was Shiller, one of the few economists who saw a major recession coming, and he did so precisely by moving away from it and by taking into account the possibility of irrational forces shaping the fate of the global economy. Some rational expectations hooligans, incapable of envisaging unemployment as something sensible within their models, went as far as stating that unemployment cannot exist and that what we see as unemployment is nothing more than a voluntary retreat from the labor market. This goes against common sense and, although the existence of unemployment contradicts the very foundations of markets, there are more sensible answers out there, as explained before. 

Among the most salient contributions of neoclassicist economists to mainstream economics is the concept of rational expectations. In economics, expectations are informed predictions that economic agents make about future trends and events. For example, thinking that next month prices are going to be higher or that the economy will continue growing are expectations. Expectations are of the uttermost importance: thinking that prices will rise could make agents change their portfolio structure in order to increase their share of non-monetary assets, or thinking that growth will be positive will make entrepreneurs decide to invest or hire more workers. Traditionally, the clumsy adaptative expectations were the ones thought to be more realistic. They envisage agents as doing their predictions based on past events. For example, since prices this month increased, next month they should be higher too; or since the economy was growing this month, it should continue doing so the next.

However, a group of economists in the 1970s and 1980s challenged adaptative expectations. Reputed names, such as Robert Barro or Robert Lucas, proposed a different approach to dealing with expectations (Ibid). If humans are rational beings, they argued, then the way they form expectations should be rational too. Expecting something to be as it was in the past is irrational, since things can and do change. As a result, rational expectations were born. This line of thought assumes that agents’ expectations will be formed through the most rational use of all publicly available information and that their expectations will, on average, coincide with reality. Rational expectations soon became mainstream, how could they not? If agents are rational then their expectations must be rational too. As Barro pointed out:

 “One of the cleverest features of the rational expectation revolution was the application of the term “rational”. Thereby, the opponents of this approach were forced into the defensive position of either being irrational or of modelling others as irrational, neither of which are comfortable positions for an economist” (Ibid). 

But, while rational expectations are theoretically sound, they do not seem very realistic. It is not very sensible to think that the owner of the bakery from which you buy bread is reading the last IMF estimations about the future trends of the global economy to decide if he should invest in another oven. Even if he did, it is difficult to imagine that he has a perfect model of how the economy works in his mind when not even Nobel Prize economists agree on how economy actually works. How could your baker know how the trend of the global economy is going to affect his investment while the IMF is recurrently incapable of estimating how this or that sector is going to react? 

Believing in rational expectations has important consequences in the real world. First of all, they fail to take into account the very real possibility, as we have seen, of recessions emerging out of irrational decisions due to emotions, ethics or simple clumsiness. Furthermore, they imply that economic policies are useless. Take a look at fiscal policy for example. Imagine the economy is in a downturn, with all the consequences that this has on people’s lives, and that the government decides to lower taxes or raise public expenditure through an emission of public debt. Since this debt will eventually have to be paid back, people will ultimately pay it either through an increase in taxes or a reduction of public services. If rational expectations were at play, individuals, anticipating this, would save in order to pay for the future burden without increasing consumption. This is called the Ricardian Equivalence and, at the end, affirms that fiscal policy is pointless. This is of course not true, fiscal policy does usually work. Continuing with our recession, imagine that the government decides to use monetary policy instead. By increasing the growth rate of money, the government expects a shift of savings into capital as a result of the change in the relative rate of return. Nevertheless, if expectations were rational, the only thing that would happen would be an increase in the nominal rate of return with no real effect on the structure of savings. This is called the Fisher Effect and entails that monetary policy is pointless. This is clearly not the case; monetary policy does work most times. By believing in rational expectations we fall into an unrealistic complacency that does much harm to a lot of people whose suffering could be relieved. 

The European Central Bank (source)

A more Sensible Assumption about Human Nature

The aim of this article is not to say that human beings are always irrational. They actually behave like true homo economicus when it comes to their economic decisions most of the time. But assuming that this is always the case and, more dangerously, taking it to the extreme, jeopardizes both the discipline and our responsiveness in times of crisis. Humans sometimes depart from the self-seeking rationality assumption. In some cases, it causes no major trouble, such as in our experiment example, in others the consequences can be dire, such as in the creation of financial bubbles. It is important to be aware of this and employ mechanisms and measures that can prevent the disaster. Furthermore, expanding the assumption to include all aspects of the discipline might be theoretically sound but it is utterly unrealistic. As we have seen, believing in rational expectations is turning the homo economicus into dogma, which can have painful consequences. Mainstream economics needs to take into account the critiques made and start considering that humans might not be as rational as they are thought to be. 

References

Akerlof, G.A. & Yellen, J.L. 1990, "The Fair Wage-Effort Hypothesis and Unemployment", The Quarterly Journal of Economics, vol. 105, no. 2, pp. 255-283.

Akerlof, G.A. & Shiller, R.J. 2009, Animal Spirits, Princeton University Press, New Jersey.

Greenspan, A. 2013, Never Saw It Coming: Why the Financial Crisis Took Economists by Surprise, Council on Foreign Relations.

Keynes, J.M. 1997, The general theory of employment, interest and money, Prometheus Books, Amherst.

Snowdon, B., Vane, H. & Wynarczyk, P. 1994, A Modern Guide to Macroeconomics, Edward Elgar Publishing, Vermont.

Edited by Hiba Arrame