The latest in a series of conversations with leading intellectuals in collaboration with the Social Science Bites podcast and the Social Science Space website.
By David Edmonds & Nigel Warburton
Robert J. Shiller, Arthur M. Okun Professor of Economics at Yale University in Davos, Switzerland, on January 28th, 2012. (Photo: World Economic Forum/Wikimedia Commons)
Robert J. Shiller, the recipient of the 2013 Nobel Prize in economics, is a best-selling author, a regular contributor to the Economic View column of the New York Times, and a professor of economics at Yale University. His books include Finance and the Good Society, Animal Spirits (co-written with George A. Akerlof), The Subprime Solution, and The New Financial Order. He lives in New Haven, Connecticut.
David Edmonds: You have a choice: Buy this plastic alarm clock right next to where you are standing for $28 or walk 10 blocks and buy it in another shop for half price, $14. Now try this one: Buy a laptop for $1,995 in the shop next to you or walk 10 blocks and get it for $1981. The chances are you are more likely to walk to save money when buying the cheap clock than the expensive laptop, which is odd because in either case you could save exactly the same amount of money. In the past 20 years there has been a revolution in economics with the study not of how people would behave if they were perfectly rational, but of how they actually behave. At the vanguard of this movement is Robert J. Shiller of Yale University.
Nigel Warburton:The topic we are going to focus on is behavioral economics. Now, we know roughly what economics is, but what’s behavioral economics?
Robert J. Shiller:Well, the word “behavioral” refers to the introduction of other social sciences into economics: psychology, sociology, and political science. It’s a revolution in economics that has taken place over the past 20 years or so. It’s bringing economics into a broader appreciation of reality. Economics was more behavioral 50 or 100 years ago. At Yale University, where I work, 1931 was the year when the department of economics, sociology, and government was split into three separate departments.
Warburton:Why would it matter if they just split the departments up? There’s an argument that specialization allows people to progress further in their field and is preferable to knowing a little bit about everything.
Shiller:Absolutely. There are both advantages and disadvantages of this structure. The advantage is that we develop mathematical economics and mathematical finance to a very advanced level — and that’s useful: We have option pricing theory that is very subtle and allows complex calculations that have some relevance to understanding these markets. But it loses perspective on why we have these options anyway. It offers a justification typically that involves rational behavior. You can get into the swim of that, thinking, “I want to know why smart people use options.” It’s instructive to go through the exercise of thinking, “Is it really ever right to buy these investment products?” But that doesn’t mean that you’re answering the question why people really do buy options, and why this market exists, and why other markets that sound equally plausible don’t exist.
Warburton:So what you’re saying is that traditional economics has focused on an ideally rational individual, asking, “What would such a person do if he or she behaved in their own best interests based on the information available?” But behavioral economics brings in the fact that we don’t always behave in our own best interests.
Shiller:That’s right. Conventional economics misrepresents what our best interests are. A great example is the financial crisis that began in 2007. The way it began was home prices started falling rapidly. Many people had committed themselves to mortgages and now the debt was worth more than the house was worth; they couldn’t come up with the money to pay off the mortgage, and it led to a world financial crisis. So why did that happen? Conventional economic theory can’t seem to get at the answer, which I would say is that we had a speculative bubble driven by excessive optimism, driven by public inattention to risks of such an eventuality, and errors in managing the mortgage contracts that were made. There are no errors in conventional economics: it’s all rational optimization.
Warburton:Well let’s take the optimism that you described. Many people were incredibly optimistic about the never-ending increase in house prices. There’s a sense that they were just ignoring past oscillations. Is that a basic trait in human beings, that we are particularly optimistic: When we see things getting better we think they are always going to get better? Or is it something very specific to this case?
Pacific Standard is running a series of excerpts from Big Ideas in Social Science, a collection of interviews from the
podcast. (Photo: SAGE Publishing)
Shiller:It’s always more specific to the case; it depends on framing how you think about the problem. Kahneman and Tversky, two psychologists very important in behavioral economics, talked about the so-called “representativeness heuristic.” We tend to look for patterns in the data that we think are representative of history. And we have salient images of things that have happened, like home prices always going up: they’ve always gone up in our lifetime. You might look for some break because you also have another model in your mind, which is 1929, and the stock market crash. So you have people looking for these patterns. While home prices were going up and up it just seemed as if anyone who raised the observation that they might fall wasn’t making an intuitively plausible observation. Until they started falling! The other template that’s in their mind suddenly becomes real and then that causes a self-reinforcing drop. The amazing thing is that, in the economics profession of 20 years or so ago, there were no bubbles. Now people freely say “bubbles,” but it was one of those words that was considered unprofessional by economists because markets are smarter than any of us and anything that happens in the market has a rational explanation.
Warburton:If we bring psychology back into economics in relation to the current crisis, what particular light would psychology shed on that? You mentioned people’s optimism. Is it that there’s a kind of herd mentality and the markets mirror that? Or is something else going on?
Shiller:There’s a lot going on. It turns out that the human mind is very complicated. Economic theory likes to reduce human behavior to a canonical form: the structure has been, ever since Samuelson wrote this a half-century ago, that people want to maximize their consumption. All they want to do is consume goods; they don’t care about anyone else. There’s neither benevolence nor malevolence. All they care about is eating or getting goods and they want to smooth it; they described it in terms of so-called “utility functions through their lifetime,” and that’s it. That is such an elegant, simple model, but it’s too simple. If you look at what psychology shows, the mind is the product of human evolution and it has lots of different patterns of behavior. The contributions that psychologists make to economics are manifold.
Warburton:One that I know you’ve discussed is that a notion of fairness might trump economic rationality.
Shiller:A sense of fairness is a fundamental human universal. It’s been found in some recent studies that it even goes beyond humans, that higher primates do have some vestigial or limited understanding of fairness and equity. In terms of how the market responds to crises, economists assume that everything is done purely out of self-interest. And yet non-economists, when we ask them about how things work — they have a totally different view. In one of my questionnaire surveys we asked something like this: If the economy were to improve, what would your employer do?
A. Nothing — why should he or she help me just because the economy goes up?
B. Well, if the economy were to improve, that would mean the market for my services would improve, so my employer would realize out of self-interest that he or she would have to raise my wage in order to keep me.
C. My employer is a nice person and he would recognize that he or she should share the benefits with employees.
I gave this question to both economists and non-economists. The economists all picked B, or, rather, most of them picked B. They thought that market forces would dominate. Whereas very few of the non-economists did: they thought either their employer was a bad guy which is A, or their employer was a nice guy, and that’s C. So there’s a different worldview, and I think that if people think that fairness is such an important thing in labor contracts then modeling the world as if it’s of total insignificance is wrong.
Warburton:So doesn’t this just make everything much, much more complicated because you can’t reduce individuals then to some kind of cipher where they are simply maximizing their self-interest in terms of economic benefits?
Shiller:That’s why a lot of economists don’t like this. Maybe with some justification they’ll say that there are too many details in this theory: you can’t explain anything with it. But I’m unpersuaded by that criticism because, first of all, we can work on this and study people more, and understand what psychological principle is relevant. And, secondly, it doesn’t help to have a theory based on wrong assumptions.