Month: February 2016

I know what you are thinking.  Did I make a typo here?  Don’t most economists believe in perfect rationality?  So isn’t the myth that people are rational?  No and No.

It is true that up until 10 or 20 years ago, the assumption of mainstream economics was of rationality.  Yet thanks (or no thanks) to the explosion of the (sub)field of behavioral economics, mainstream economists today operate with the assumption that individuals make all sorts of “irrational” decisions.  And economics use this assumption of irrationality to explain all sorts of so called “market failures” (see Myth #2) and to justify all sorts of government intervention to counteract these irrationally fueled market failures.

The truth is that individuals are indeed rational, yet neither the economists of yesteryear nor the economists of today get it right because they both are using a poor definition of the word “rational.”  The correct definition of a rational decision is one that you believe will make you best off (to be technical, that you believe will maximize the present value of your future utility).  It is not necessarily the decision that you believe will maximize your income or wealth.  It is not necessarily the decision that you believe will maximize your current utility or happiness.  It is not necessarily the decision that will actually make you best off.  You may make a poor decision for lack of information, due to miscalculation, stupidity or any other reason, but as long as you believe you are making the best decision for you, you are acting rationality.

Virtually all of the so-called “anomalies” to rational behavior that behavioral economics have “discovered” in recent decades are not truly “anomalies” if you use the proper (and colloquial) definition of rationality.  In other words, behavioral economics, though sometimes mildly interesting, is hardly worthy of the attention it has received.

And by the way, financial bubbles (which can and do exist) have absolutely nothing to do with investor irrationality.  I’ll have a lot more to say about the subjects of utility and rationality in a future post, but in the meantime remember to be skeptical whenever you hear economists justify government intervention in markets due to “irrational behavior.”

I am of the opinion that mainstream economics gets most things wrong.  Mainstream economists pretend to be scientists when they are not, use unrealistic assumptions to create simplistic models, confuse correlation with causation, ignore history, are biased towards action over inaction and favor the short-term over the long-term.  Perhaps more importantly than anything else, mainstream economics has forgotten the lessons of Adam Smith and fails to appreciate what a free market really means, and does not mean.

My criticisms are not original.  In fact, many if not all of them are held, though not widely held, by those outside the economics community.  Naturally, if economists were like all other members of the social sciences, these criticisms would be, well, academic, just like economists are supposed to be.

But economists are not just academics.  To paraphrase Keynes, policy makers are, “usually the slaves of some defunct economist.”   Economists have escaped from the ivory tower and have become entrenched in both government and finance.  In fact, economists have come to influence our world more than members of perhaps any other profession.  Worse, they have become the policy makers, but with less oversight and more power.

This has not been to the world’s benefit. I will go as far to say that economists, especially through their role as central bankers, have done more damage to the world than anything since World War II.  And not because they are malicious or evil like Hitler or Stalin.  Economists mean well.  They believe they are helping.

No, it is because they are clueless.  Not simply clueless to the damage they have caused (for they will of course deny this), but clueless to even the power they possess. And not because they are dumb.  On the contrary, they are mostly smart.  In many cases very smart.

Modern society fetishizes intelligence.  We are educated to believe and thus take for granted that smart people make the right decisions.  This is wrong.  It is not high intelligence that is the making of good policy, but wisdom.

Wisdom requires self awareness.  You must know what you don’t know.  Wisdom requires humility.  You must be able to admit what you don’t know.  Wisdom requires an understanding of history.  You must be able to see and appreciate the bigger picture.  Wisdom requires an understanding of human nature.  You must be able to interpret what fundamentally motivates people.

Economists don’t lack intelligence.  But they do lack wisdom. They have a false understanding of what drives decision making.  They are required to learn no history in their economic studies.  They act before they understand.  And most importantly, they take for granted what they should question.  It is not simply that they rely on assumptions that are unrealistic or wrong.  It is that they make assumptions that they don’t even realize they are making.

Over the next ten posts, I will highlight, in no particular order, what I believe are the ten largest myths of mainstream economics.  These are assumptions that I believe economists get wrong because they are unwise.  And the world is much worse-off because they get these assumptions wrong.  On many of these myths, I will have much more to say in the future.  But for now, I ask you to settle for rather short explanations.

Myth 1: People are irrational

Myth 2:  Market failures are common

Myth 3:  Insufficient aggregate demand causes recessions

Myth 4:  Central banks can micromanage the economy and prevent recessions

Myth 5:  Deflation is always bad

Myth 6:  Moderate inflation is good

Myth 7:  Liquidity in financial markets is always good

Myth 8:  There is such a thing as fundamental value

Myth 9:  Equilibrium exists

Myth 10:  Entrepreneurship is always good

Bonus Myth:  “In the long run we are dead”