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

In the Name of God: How Israelis, Palestinians and Americans Transformed the Arab-Israeli Conflict into a Religious Struggle

The Arab-Israeli conflict, primarily a dispute over the control of land, has passed from being framed in nationalistic terms by both Arabs and Israelis and in more or less strategic terms by the US; to being understood as a religious conflict, underpinned by a religious shift in the mindset of its parties, including America. Israel’s religious radicalization gained momentum during the Oslo negotiations, crystallizing with the assassination of Prime Minister Rabin, and continuing today, notably under the harsh policies of Benyamin Netanyahu. The rise of Palestinian political Islam can be traced back to the general “Islamic Resurgence” of the 70s, that swept all over the Muslim world, though it has become more evident in the late 20th and early 21st Centuries. In America, the impact of Evangelical Christian ideas on US foreign policy began under the presidency of George W. Bush but reached its peak of influence under the Trump Administration.

Yitzhak Rabin, Yasser Arafat and Bill Clinton at the Oslo Accords signing ceremony, 1993 (source)

Israel’s religious right-wing has been growing in size and makes up an important part of Netanyahu’s government. During the last decades, secularist-nationalist extreme right has been losing ground to a more religious kind of far right, with terrorist attacks, especially in the occupied territories, multiplying. This trend was painfully evident in 1995, when ultra-orthodox media held symposiums on the question of whether Yitzhak Rabin should be executed, and when fundamentalist rabbis condemned the Prime Minister and declared it legitimate to assassinate him, leading to the consequences that we all know. From its part, Islamist fundamentalism has seen its public support and reconnaissance grow dramatically during the 21st Century, especially at difficult times. For example, Palestinians’ support for groups like Hamas or Islamic Jihad increased by more than 50% during the so-called Al-Aqsa Intifada. Meanwhile, in the United States, Evangelical Christians have gained important leverage in the design of US foreign policy, particularly in what concerns the Arab-Israeli conflict. The group Christians United for Israel (CUFI) founded in 2006 and that claims more than four million members, has an important influence in Trump’s decisions. When the new American embassy in Jerusalem was inaugurated, an extremist pastor called Robert Jeffress thanked God for “having given us a president who boldly stands on the right side of history, but more importantly, stands on the right side of You, of God, when it comes to Israel”.

The Battle for the Soul of Israel

Although right-wing extremism has always been part of the country’s political landscape, the new far right is underpinned by a religious fundamentalist ideology, in contraposition to the traditionally nationalist right. Modern Israel was created by a group of secular socialists led by David Ben-Gurion, that wanted to build a more or less secular and liberal state for the Hebrew nation after the horrors of the Holocaust. This idea was shattered after the Yom Kippur war in 1973. Although Israel ultimately won the war, losses were huge, and the massive intelligence failure destroyed the credibility of traditional Labor policies. Menachem Begin won the next elections, inflicting a painful defeat to the Labor party, and forged an alliance with Israel’s religious parties, which demanded important concessions to the ultra-orthodox. This sowed the seeds for fundamentalist right-wing extremism. The focus of right-wing parties started to swing from land and security to the transformation of Israel’s population into a homogeneous Jewish society. 

The Arab-Israeli conflict was not regarded as a religious one until the 1980s, a time when Israel’s nationalistic far right turned into a religious one. The transformation of the conflict into a sacred battle through the vilification of Palestinians legitimized violence against civilians. These new right-wing parties understand democracy as an anomaly that will eventually give place to a truly Jewish state, and have ultraconservative values at the backbone of their ideology. They offer orthodox Judaism as an alternative to secular and democratic Zionism.

These ideas seem to be gaining support. In 2016, a Pew public opinion survey found that almost 80% of Jewish Israelis support “preferential treatment” for Jews, this is, full rights for Jews and discrimination and suspicion for gentiles. At the same time, the vast majority of Israelis are proud of having a stable and functioning democracy. However, the increased radicalization of Israeli politics has driven the country to a crossroad, if the criterion of inclusion is not based on citizenship but rather on religious affiliation, the same concept of democracy is undermined. Since one of the pillars of democracy is the equality of all citizens before the law, any law that violates this principle would be, by definition, antidemocratic. Thus, religious right-wing parties are right, it is not possible to live in a Jewish democratic state, Israelis must be aware that right-wing extremism not only harms Palestinians, but also undermines the democracy they are so proud of. 

The Islamic Alternative

The rise of Islamic fundamentalism is, of course, nothing exclusively Palestinian. This “Islamic Resurgence” can be traced back to the 1970s, and, even though it swept with force most of the Muslim World, the Arab-Israeli conflict is at its center, at least if we are to explore its causes. After the decolonization of the Middle East, Arab nationalism emerged as the new way to make politics in the region. Fiercely anti-Israeli and nationalist, the Egyptian president Gamal Abdel Nasser, personified the ideals of this doctrine. Nasser rose to power through a coup d’état against King Farouk, and gained the respect of Arabs across the region, feeding in the popular resentment produced by the defeat of the War of 1949 and the dire economic conditions. 

Palestinian children greeting Hamas fighters in Gaza (source)

However, Nasser was incapable of facing Israel, suffering humiliating defeats and losing important swaths of territory. This was not solely an Egyptian affair, Arab nationalism seemed to be failing everywhere, and the Palestinian cause was losing attraction. Furthermore, the socialist economic mismanagement of Arab governments did not improve people’s economic conditions, but rather deteriorated them. Amid all of this, the feeling that the current political, socioeconomic and cultural systems were a failure spread among the population, and political Islam, underpinned by the thinking of Qotb and Maududi, started to seem like a self-sufficient ideology for the state and society, a viable alternative to nationalism. The year 1973 is paradoxical, while nationalists were again defeated at the Yom Kippur war, the conservative gulf monarchies inflicted great pain to Western economies without even having to use a single soldier, at the same time their GDPs boomed. Political Islam finally crystallized in 1979, when Afghan mujahidin were able to stop the Soviet Empire’s advance, an Islamic revolution triumphed in Iran and Anwar Sadat, Nasser’s successor, signed a peace treaty with Israel, what was seen as the final claudication of Arab nationalism. 

The Islamic upheaval of the Palestinian political landscape took a little bit more to be evident, mainly because the PLO, under the direction of Yasser Arafat, distanced itself from Arab nationalism in the late 1960s. However, 1993’s historic handshake between Yitzhak Rabin and the Palestinian leader in the framework of the Oslo Accords was considered to many a betrayal to the Palestinian cause. Furthermore, the continuous victories or at least stalemates of Hizballah against Israel during the 80s, 90s, and early 2000s galvanized the idea of political Islam as a viable way of defending Palestine. At the same time, Islamic organizations like Hamas provided social and economic relief to an agonizing population while the Palestinian Authority’s capacity to provide basic services was greatly reduced. During the first years of the 21st Century the Palestinian political front finally imploded, a generational breakdown became evident between the old PLO/PA cadres that refused to participate in the Intifada, and the young Islamists. The Palestinian Authority rapidly lost legitimacy at home and abroad, weakened by its inaction against Israeli attacks and plagued with corruption; at the same time that groups like Hamas or Hizballah gained widespread support.

America’s Prophetic Duty

The United States’ approach to deal with the Arab-Israeli conflict has historically been a rational and strategic one, aimed to protect American interests in the Middle East and the stability of the region through a peaceful solution to the conflict. Proofs of this are the numerous attempts, some successful others not, to reduce tensions and foster communication among the parties involved. It could not have been possible for Egypt to get back the Sinai or for Israel to get its right to exist recognized by the PLO, without the American involvement. 

It is true that the United States has always had a preference for Israel, and that the generosity upon which is based their relationship is not comparable with the shallower aid that Palestine receives. However, George W. Bush and, more notably, Donald Trump, have adopted an increasingly pro-Israeli rhetoric and have undermined their relations with the Palestinian people. The final materializations of this shift are the decision to move the US embassy from Tel Aviv to Jerusalem, and thus recognize Jerusalem as the capital of Israel, and Kushner’s “Deal of the Century” that does everything to foster Israeli interests and nothing to protect Palestinian ones.

A prayer at an Evangelicals for Trump campaign event (source)

This shift is better understood if we have a look at the United States political map. More than a quarter of all eligible voters in America are white Evangelical Christians. This makes them a juicy base of electoral support to have, and the Republican Party has taken the lead. More than 80% of white Evangelical Christians voted for Trump, and the President has been eager to foster Evangelical objectives through his policies. Evangelical Christians believe that the Bible is some sort of prophetic roadmap that ends with the Day of Judgement and the second coming to Earth of Jesus Christ. In this day, the faithful will go the heaven and the sinners to hell. The prophecy also talks about an important event for the analyzed conflict: the second coming of Jesus Christ will be precluded by the return of the Jews to the land of Israel. Thus, the simple existence of Israel is seen by many Evangelical Christians as the sign that confirms the prophecy, and, for them, if the United States wants to be in the right side of history, it must do everything in its hands to protect Israel and defeat its enemies. This could also explain the harsh measures that Trump has undertaken against Iran, notably, since another passage of the Bible taken literally by Evangelicals, Esther’s Book, talks about a plot by the King of Persia (modern day Iran) to destroy the Jews. Furthermore, it is important to have in mind that two of the most powerful men in designing US foreign policy, State Secretary Mike Pompeo and Vice-president Mike Pence, identify themselves as Evangelical Christians. 

The Wrong Road

Framing the conflict in religious terms does nothing to solve the problem but rather drives it to a dead end. If the Palestinian efforts continue to be led by intransigent ecstatic groups that understand the struggle as a zero-sum game in which the ends always justify the means, the Israeli state continues its shift towards maximalist policies entrenched by radical conceptions about the fate of the nation, and the US policy continues to be driven by some sort of prophetic responsibility, the conflict will turn into an even bitterer rivalry than it is today. Islamic terrorism will not weaken the Israeli state, but rather provoke more severe responses. Israel’s settlement and homogenization policies will not make the nation safer, but rather create an environment of constant insecurity embedded in an apartheid system deeply antidemocratic. Trump’s “Deal of the Century” will not solve the parties’ differences, but rather exacerbate violence in an already turbulent region. By understanding the conflict as a religious struggle, all factions have transformed it into a cosmic battle in which the opponent is nothing short of a demon that must be destroyed. Israel, Palestine and America are driving themselves to the antipodes of a peaceful settlement, the looming shadow of the Clash of Civilizations seems closer than ever. If the parties are not able to moderate themselves, violence, hatred and pain will continue to be their daily bread for a long time. 

References:

1. Benn, A. 2016, "The End of the Old Israel", Foreign Affairs;

2. Hanauer, L.S. 1995, "The Path to Redemption: Fundamentalist Judaism, Territory, and Jewish Settler Violence in the West Bank", Studies in Conflict & Terrorism;

3. Hernández Jiménez, A., B. Culla, J. & Bermejo García, R. 2012, "Las raíces del Estado de Israel y su evolución", Historia del Estado de Israel, 2012;

4. Keim, M. 2011, "Here and Back Again: US National Security Interests in the Arab/Israeli Conflict", Pepperdine Policy Review;

5. Rouhana, N.N. 2006, "Jewish and Democratic? The Price of a National Self-Deception", Journal of Palestine Studies;

6. Roy, S. 2003, "Hamas and the transformation(s) of political Islam in Palestine ", Current History;

7. Scheltens, L. & Parvaneh, D. 2020, Feb 12, How a Bible prophecy shapes Trump’s foreign policy;

8. Shikaki, K. 2004, "The Future of Palestine", Foreign Affairs.

Edited by Hiba Arrame