The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.
As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.
You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.
The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. As the statistician Leonard “Jimmie” Savage showed in 1954, if people follow certain axioms of rationality, they must behave as if they knew all the probabilities and did all the appropriate calculations.
So economists assume that people do indeed use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. They are not influenced by anything but the facts, and probabilities are taken as facts. They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed.
Abundant psychological evidence, however, has now shown that people do not satisfy Savage’s axioms of rationality.
In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn’t seem to be a mere repetition of a quantifiable past. For many people, it seems that “this time is different.”
The work of Duke neuroscientists Scott Huettel and Michael Platt has shown, through functional magnetic resonance imaging experiments, that “decision making under ambiguity does not represent a special, more complex case of risky decision making; instead, these two forms of uncertainty are supported by distinct mechanisms.”
In other words, different parts of the brain and emotional pathways are involved when ambiguity is present.
Mathematical economist Donald Brown and psychologist Laurie Santos, both of Yale, are running experiments with human subjects to try to understand how human tolerance for ambiguity in economic decision making varies over time.
They theorize that “bull markets are characterized by ambiguity-seeking behavior and bear markets by ambiguity-avoiding behavior.”
These behaviors are aspects of changing confidence, which we are only just beginning to understand.
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