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Beyond the Homo Economicus

The Homo economicus is a kind of calculating machine on two legs who incessantly calculates personal benefits and profit. His conduct follows the model of rational expectations and assumes all other persons will follow this model.. Incursions of the state should make possible more social equality. Finance-driven capitalism is based on myths and false models.

Rationality of Economic Subjects. Economic journalist Martin Wolf in conversation with Stefan Fuchs

[This discussion published on: dradio.de 11/13/2011 is translated from the German on the Internet,  http://www.dradio.de/dlf/sendungen/essayunddiskurs/1602354/.]

[When the greatest worldwide economic crisis since 1929 broke out in the fall of 2008, the overwhelming majority of economists stood naked. Hardly one had seen the catastrophe coming. Modern economics with its single-minded faith in the rationality of economic subjects was the first victim of the crisis.]

After the crisis, we know quasi natural laws are not valid any more. In our conversation series "Economic Wise Men at a Loss!" Stefan Fuchs focuses on the failures and omissions of the national economy and the political consequences. His first conversation partner is the British economics journalist Martin Wolf, chief economist of the "Financial Times."

Stefan Fuchs: Mr. Wolf, the contradictions within the discipline still seem unbridgeable at the fourth Lindau economics meeting where the majority of living Nobel Prize winners for economics gathered. For example, Robert B. Myerson from the University of Chicago is convinced the modern macro-economy made the world better. This remark almost calls to mind the remark of former president Bush that the intervention in Iraq made the world better. On the other hand, Joseph Stiglitz from Columbia University in New York blamed the neoclassical standard models of economics for the financial crisis of 2008.

Where do you stand in this conflict? Wasn't the conflict of economic schools really decided by the greatest economic crisis since 1929?

Martin Wolf: I will not comment whether the Iraq invasion of President Bush made the world better. That is not my theme. However both sides could advance arguments for their respective positions in the dispute of Nobel Prize winners. Stiglitz' very critical opinion convinces me more than the cheerful optimism of a representative of neoclassicism like Myerson.

When the crisis broke out over us in the fall of 2008 with the bankruptcy of Lehman Brothers, economic experts reacted very differently than in the 1930s when industrial states were haunted by the worldwide economic crisis. This time people knew how they had to react. The doctrine of self-healing powers was forgotten and the financial markets were stabilized through massive and courageous monetary and fiscal measures. Enormous deficits were consciously accepted and gigantic sums of money pumped in to stimulate the economy and the economic circulation. So the worst could be prevented.

These successes should not be ascribed to the advances of the modern macro-economy. Everything needed for the modern economy has been well-known since the 1970s, especially the crisis-coping strategies developed by John Maynard Keynes on the basis of experiences with the worldwide economic crisis. Thus an older macro-economy forms the theoretical foundation.

On the other hand the neoclassical economics of the last forty years neither predicted the crisis nor contributed anything to its mastery. Its basic assumptions of the model of rational expectations, the theory of real economic cycles for which there was a whole series of Nobel prizes and the hypothesis about the efficiency of markets strengthened politicians' deceptive optimism that the economy on principle is stable if only left to itself.

Since the late 1970s, the dominant economic theories led to deregulation and an enormous expansion of the financial markets. They contributed to the monetarist fixation on controlling the money supply and massive imbalances in income distribution. Their dictation has increased social inequality enormously. Balance of trade defici8ts were simply ignored on the basis of these models.

Joseph Stiglitz' fundamental criticism is legitimate. When a crisis comparable to the 1928 worldwide economic crisis erupted over us, we had to forget all these abstract models and bid farewell to the notion of self-regulating markets. All of a sudden we had to remember what our forefathers and foremothers learned in the thirties, forties, fifties and sixties.

Fuchs: We reacted in a surprising Keynesian way. Now the pendulum seems to be swinging back and we are suddenly again in a situation where the old explanations of neoclassicism are invoked again, namely savings! Is that right? Do you also see it that way? Are we now in a second stage of crisis mastery?

Wolf: The first question is why the world rejected Keynes. The answer is a classic example for the changing fate of ideas in the social sciences which includes economics. The Keynesian paradigm that was of great usefulness under certain historical conditions was then wrongly applied under conditions that do not exist any more. This led to Keynes' rejection. In the 1960s and 1970s, the so-called "stagflation" occurred that can no longer be explained with traditional Keynesian theory...

The triumph of market optimism in the last 30 years led to decisive changes in the functioning of the economy. The result is an excessive liberalization, the dominance of the financial sector, radically changed values in business administration, growing inequality of incomes and suppression of the primacy of politics. Perhaps people in their feelings and values come a little closer to the model of the hardened Homo economicus focused only on profit maximization.

Economists like to repress this and cling to the illusion that their themes are unchangeable as in a natural science and not social.

A certain view of the person underlies the model of rational expectations. The problem is only that it is based on the assumption of the absolute rationality of human conduct. The Homo economicus is a kind of calculating machine on two legs who incessantly calculates personal benefits and profit. His conduct follows the model of rational expectations and assumes that all other persons follow this model without restrictions. The stability of the economy is not a problem when all market actors orient their conduct in the model of absolute rationality. But this is an undue inadmissible simplified and very unrealistic abstraction of human conduct and human knowledge.

There is no way ou9t of these uncoupling processes between science and its scientific subject. Economists must be aware that their theories change society. This may not hinder them in their further reflection.

Fuchs: Does that mean economics is a social science, a "soft science," that does not correspond to the ideals of a natural science "hard science"?

Wolf: A demarcating line between "soft" and "hard science" is hard to draw. Economics is a "hard science" in the sense of difficult. Two facts establish this special difficulty in economics. Firstly, extremely complex systems are involved. Here the economy is comparable with climate research. Predictions are very difficult for complex systems with infinitely many interactions. Economics is a discipline with people as its theme. People have very different motives and values that influence their conduct and cannot be reduced to the motive of abstract self-interest. People are guided by a certain interpretation of the world. These interpretations change the world and affect worldviews. A complexity is reached that even surpasses the dissimilar relations of quantum physics. Finally, elementary particles unintentionally hide their true nature from researchers. People and social institutions do this constantly. This confronts the discipline with an epistemological dilemma. It has to simplify extremely. Thus people are assumed to essentially seek their self-interest and multiplication of profit and are intelligent enough to reach these goals. We know this is not the whole truth. Still it is amazing how far we have come with these extreme simplifications in the last 250 years and how much economic understanding was possible. But the validity of this abstract model has clear limits. The problem is recognizing these limits and not making predictions when these limits are exceeded. If that does not happen, the useful discipline becomes a danger for the general public.

Showing these limits was one of Keynes' great achievements. His concept of radical uncertainty calls in question the predictability of future economic processes. Panic arises when this uncertainty exceeds a certain measure. General total panic suspends all normal economic conduct. That happened in the crisis of 2008.

Fuchs: There is also the historical aspect. This whole system has become much more complex in the last 30 or 40 years through modern information technologies and new financial instruments like derivatives. This means the attempt of economics to intervene becomes harder to recognize.

Wolf: That is true but is not as new as one might assume. When one views the last 600 years of economic history from a great distance, the trend to increasingly more complex social arrangements cannot be ignored. This includes a progressive division of labor and an ever more skilful handling of risks. For example, the risk of a famine belongs to the past in developed societies today. 300 years ago this was very different in Europe. Today risks are essentially manmade and not so much consequences of natural phenomena. 400 years ago there were serious financial crises. Charles Kindleberger described this very beautifully in his famous book "Manias, Panics and Crashes." The increasing complexity has accompanied us for a long while. Attempts at regulation and control usually lag behind in this process. Crises occur. They are overcome and nevertheless return again and again. At the same time we can protect ourselves from more and more risks through increasingly complex instruments. Take life insurance for example. This is a very complicated product. It presupposes a whole series of mathematical techniques and statistical knowledge about life expectancy.

Much is possible with the computer. The risk that something may go wrong also increases. Whether the system as a whole is more unstable today than in the 1930s is an open question to me. The volatility in some areas cannot be ignored. Part of that is due to political mistakes that the banking system was allowed to operate withy much too little capital reserves and completely false incentives. Another part is caused by the technologically-intensified feedback processes in the financial markets as you described.

In the 19th century, there were also a great number of breakdowns, stock- and bank crashes and many recessions. The difference is that we do not accept these catastrophes today. We have the ambition to control economic events as smoothly as possible. Market-based systems on principle are unstable. Removing this instability from the markets is very hard. At the same time it is very hard to manage without markets. This is a dilemma of humanity and not only of economics. Progress often produces great dangers.

Fuchs: The social sciences are always influenced by interests, political currents and social groups that support them. It may not be an accident that modern macro-economics is an export of American universities. What are the social interest groups behind this dominance of the modern macro-economy that are bound with the rational expectation theory, the liberation of markets and so forth?

Wolf: In the middle of the 20th century, the center of scholarly activities shifted from Europe to the West across the Atlantic. Economics was not an exception. Europe was weakened by the war. Many of its intellectuals were in exile. The US emerged from the war as victor. The American university system was reformed and dominated many if not all research disciplines. In the Cold War, the dominance of US universities was the stated goal of American politics. This context should be kept in mind be cause other wise conspiracy theories run riot.

In relation to economics as a social science, I also raise the question to what extent this US dominance of the discipline has a cultural stamp. Two schools must be distinguished. Firstly, there is the so-called "saltwater school" of economics taught at universities on the east coast like Harvard, MIT and Princeton. Those institutions that arose with Roosevelt's "New Deal" are endorsed. Incursions of the state should make possible more social equality. Therefore the dysfunction of the markets and the underlying uncertainty about future developments are emphasized. The unions and parts of the old big industry are the social interest groups behind this view of things.

The so-called "freshwater" school of economics whose Mecca is the University of Chicago stands for an extremist individualism. At most the state should be concerned with protection of property and inner security. The markets by themselves ensure general prosperity. The social interest groups that support these theories should obviously be sought more on Wall Street than with the big auto manufacturers in Detroit.

These are the two great schools of US economics that represent two diametrically opposed models of society in the American history of ideas. That does not explain these theories but explains the acceptance they have found and the influence they exert.

Fuchs: Mr. Wolf, let me end this conversation with a question about the future of the discipline. You were one of the co-founders of the Institute for New Economic Thinking. Where do you see the fields in which the economy must be engaged in the future? Interdisciplinarity is certainly an important keyword. This is true for the economy and for all other disciplines. Where are the new fields of research, neuro-economy, and integration of psychology or behavioral economy? Where would you say are the main building sites for the future?

Wolf: I wish I knew the answer. If I knew, the problem would not be as difficult as it obviously is. The task of doing justice to the challenge of today's economy is incredibly hard. A complete reform of the discipline not in everything but in a whole series of fields is imperative. We need new approaches concerning the macro-economy and the mechanisms of the financial markets. This new institute should tackle this. Thus it is easier for me to name the problem areas than to propose possible solutions.

The successes of economics were grounded in the strategies of radical simplification that advanced very simple pictures about the nature of humans, the functioning of society, the distribution of knowledge and available technologies. However this success is at the same time a great danger. In critical phases, these heroic simplifications obstruct the decisive factors. The question is how must and can the abstract models be supplemented and expanded while avoiding unmanageable complexity. The best map of the world is the world itself. All other maps lie in one way or another. In other words, all maps made by cartography are simplifications for certain applications. For some purposes, a flat map is enough even though the world has a spherical form. The task of economics is drawing up simplifying maps that depict the incredible complexity of economic courses.

From my perspective, two fields of research are important in this connection. One concerns a far-reaching radical revision of Homo economicus. Motivations and perception models of people are completely misunderstood. The cognitive dimension closely connected with the fundamental uncertainty of the economic subjects that we discussed is especially obscure, the basic impossibility of a future prognosis. Perhaps behavioral economics offers ideas here. I am somewhat more skeptical regarding neuro-economics. All psychological aspects of human conduct are very important so we can leave behind the insufferable abstraction of Homo economicus. Profit maximization is not the most important motive for human behavior. We seek social acknowledgment, social influence and harmonious interpersonal relations.

Institutions are the other field of research that interests me very much. All kinds of social institutions, businesses, political regulatory authorities, unions and business associations are defined by certain explicit and implicit norms. Their complex mutual relations make possible the functioning of the economic system. Institutions have their own laws. They create continuity. They give people support and can dissolve some of the uncertainty about the future. Ultimately they are an organizational form of future planning. Economics today has only a very rudimentary picture of the function of institutions. The picture that we have of businesses is an undue inadmissible simplification. We see businesses only as a web of contracts. That is completely wrong!

A whole series of other aspects must be considered here, for example the role of power. Facing these tremendous challenges will be the task of coming generations of economists. Let me repeat my creed. In the future, the disciplines will not manage without strategies of complexity reduction. The extreme complexity of economic interactions which is indissolubly interwoven with aggregate social processes and not a separate field cannot be scientifically worked on any differently. At the end, we need a map that is only a simplified reflection of the world because a map that is as complicated as the world itself cannot be read.

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