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The stupid assumptions of economists

Economics 101 has a lot to answer for. The simplistic view of human nature taken as axiomatic by economists has been adopted by regulators and policymakers with consequences ranging from bad to awful.

Among the stupidest assumptions of Economics 101 is that people make their decisions independently. Economists know this is not the case but the assumption is needed to make their models work. That is OK in the ivory towers but in the real world making this assumption leads to big policy errors.

In reality, people prefer to make the same decisions other people are making. We are lazy and assume they have done the work in figuring out whether it really is a good decision so we do not have to. This worked in the stone age – and in some contexts it still does, as you can see by the way people find the most efficient route across a partly muddy field.

But for this wisdom of crowds to work, it has to quickly narrow down options to a few whose differences are obvious. And that is not what financial markets deliver when they are left to a freefor-all and regulators assume consumers will benefit from having masses of complicated products to choose between.

Behavioural finance says people need to be nudged towards good decisions and one of the best ways to do this is to show them lots of other people like them are making the same decisions.

The Victorians, under the guidance of the greatest good of the greatest number utilitarian philosophy, encouraged people to make collective decisions. They invented self-help based on groups of people helping each other. Burial societies, building societies, friendly societies and housing trusts all embodied these principles. These mutual organisations helped people make good, life-enhancing decisions by making them simple, easy and contagious.

At the start of my working life in the 1970s there were still many building and friendly societies that embodied these values. Today there are only a handful.
Regulation has been harsh to them. When they are told they must have more capital but that can come only from profits or shareholders, mutuals are heavily disadvantaged relative to PLCs.

One in five Germans has an account with a local credit union and can borrow small sums at a fraction of the rates charged by UK banks or, worse still, payday loans or other sharkish moneylenders. In contrast, UK credit unions are hamstrung by laws restricting their activities and by regulation that treats them like commercial banks.

Revisions of banking regulation aimed at improving competition must knock the shackles off credit unions and other mutuals as well as tasering commercial banks.

We have been made resistant to the charms of mutuality by four decades of individualistic brainwashing. Social psychology (and a dispassionate look at our own experience) proves we rarely make genuinely independent decisions, yet advertising and marketing tries to convince us we are only authentic when we do. We overstate the cost of the personal effort that any form of mutuality requires but discount all the benefits of collective decision-making.

A form of mutuality that works in the 21st century will have to be different from its 19th century antecedents. There are smart people working on this but they will need a helping hand from policymakers and regulators.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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There are 12 comments at the moment, we would love to hear your opinion too.

  1. I couldn’t agree more. The almighty pound has been put before care. IFA’s I feel are more ‘vocational’ in their outlook, wishing to help people look after their financial interests with income being secondary. I don’t know a lot of really wealthy advisers but do know wealthy bankers. Most of the advisers I know chat about how they have helped clients few about the money they make. I fear for the future when ordinary people cannot afford advice and are ‘taken’ by the big banks under the watchful supervision (or non-supervision as we have now!)

  2. Hmmm, interesting article Chris.

    As someone who has been ‘classically’ trained in economics to PhD level, I agree that some of the assumptions made by economists do appear to be rather odd, when confronting the ‘real world.’ However, I fear that you have missed the point of these models somewhat. They serve an important purpose as ‘approximations’ of agents behaviour – economics is not a science akin to Biology, Physics and Chemistry, with almost irrefutable ‘laws’. Trying to model ‘real’ behaviour has become the aim of behavioural and experimental economics, which has seen great advances made in the integration of psychology with formal economic modelling.

    But the key point here is that economics models will never mirror exactly what we see ‘in the field’, and here is the important point…they don’t purport to do so! Models in economics are frameworks designed to generalise. Quite frankly, I doubt many policies have been implemented on the back of the theoretical economic models that you refer to? More common is the empirical study of the policy area in question, using data to approximate the relationships between variables of interest, and this is what is used to inform politicians / policy makers and the like.

    I’d be interested to know of a policy that has been specifically designed and implemented based on the core theoretical assumptions of completeness, transitivity and monotonicity, with reference to expected utility theory as a sensible model of people’s attitude to risk!

  3. Ben, you may have a PhD in economics (although you didn’t say whether you actually had achieved a PhD), but I would suggest that economic theory HAS always driven political and social agendas, and usually for the worse.

    The Chicago school of economics has a lot to answer for and anyone who wants to see how powerful and damaging economic theory can be (and has been) should read “The Shock Doctrine” by Naoni Klein.

    It’s terrifying ! – and you’ll never see the American Government in the same light again.

  4. To: Bill Wells

    Thanks for the comment Bill. I am actually in the last year of my PhD, studying behavioural economics – so, in a roundabout way, I agree with the fact that many of the assumptions made in ‘classical’ economics are unrealistic and potentially misleading to the casual observer. They are, however, not ‘stupid’ as Chris describes them. They are a necessary feature of formal models (i.e., the necessary stripping down of detail to generate a tractable and parsimonious approximation of behaviour) and are not designed to mimic reality – how on earth can you mimic the behaviour of millions of consumers with their own minds / motivations etc?

    However, behavioural economics has a real place in policy determination and implementation – look at policies relating to pensions, for example: auto enrolment, which is recognising that people do need the ‘nudge’ that Thaler et al talk about. Average-speed speed cameras are effective at reducing accidents and speeding because of the way in which we assess numbers and perceive the world. Many policies have been implemented on the back of serious and high level academic research by behavioural economists, and this is the type of outcome we should be focussing on. Believe in the ‘reality’ of formal economic models at your peril!!

    After all, do we denounce psychologists for failing to come up with reasons why we ‘herd’ as Chris mentioned above, instead of making our choices independently? Of course not – but at the same time, economists are fully aware that people do not make choices like robots – this is precisely the point: if you want to call economics a science, it has to have a chance to develop. Remember that these formal models have only been introduced in the last 100 years, with behavioural economics not taking hold until the 80’s, early 90’s! Compare this to the levels of knowledge in the true ‘sciences’ at these times. Research is advancing quickly, and many people realise that if economic models are to have any use (and credence) in policy decision making, then they must relate to the real world far better than they do currently.

  5. Bill,

    Forgot to mention, take a look at this link:

    Might make you think a little differently about Klein’s book…

    Naomi Klein, Michael Moore etc the list goes on. Just because they shout loudly, doesn’t mean they are right (or even accurate!).

    Just a thought.

  6. “Tasering the commercial banks” – classic line of the week for me.

    Perhaps other MM readers would like to suggest other candidates they feel ripe for tasering?

  7. Good documentary on TV last night, very relevant. Money outside the model (China) distorting everything and making things look fine and dandy

  8. Jonathan Whitham 24th May 2011 at 9:42 pm

    Surely the key point here is that models are just that – models: they are not predictors. Instead they allow us to anlayse probabilities and (hopefully) make informed decisions. It’s important, though, to look beyond the model and not be ‘slaves to the numbers’.

    That said, nowadays ‘instinct’ or ‘experience’ are often over-ruled by the need for data to back-up decisions, even though the data available can be unreliable, ambiguous and even mis-leading. However, perhaps it’s this need for evidential data, however flaky, that makes us call in to question the value of experts, even though in the round they get more things right than wrong.

  9. Ben Rees – just because the (very right wing) Cato Institute says Naomi Klein is wrong, doesn’t mean to say she is.

    After all, you wouldn’t expect them to agree with her would you?

  10. @ Mark (10.01am):

    Precisely – Bill was ‘terrified’ by the ‘revelations’ of Klein and implied that we all should be. I was merely pointing out the other extreme view!


  11. chris gilchrist 26th May 2011 at 9:43 am

    Ben, I know perfectly well that the models are just models, and that’s fine – the problem is when policymakers adopt those models as prescriptive – as with Chicago school economics being adopted by Reagan and Thatcher. I don’t think you recognise how much economic policy is based on 101. And remember Keynes’ comment about politicians and dead economists.

  12. Chris – of course, blindly adopting theoretical models as prescriptive is extremely dangerous. Reminds me of the quote by Thomas Sowell:

    ‘The first lesson of economics is that we live in a world of scarcity. There is never enough of anything to satisfy all those who want it. The first lesson of politics is to ignore the first lesson of economics.’

    I think the problem lies very much in what has already been said in previous posts: economic models are always generally derived from either abstract musings or PAST data, both of which most certainly do not provide an accurate prediction of what WILL happen in the future.

    Given that many politicians these days are trained economists (Cameron, Balls, Miliband (s) etc) it is a wonder that they are not more aware!

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