The financial crisis: Why did no-one see it coming, and why did economists get it so wrong?

Why didn’t the experts see it coming?, asked the Queen of England, and the British Academy wrote a letter to explain. Of the lead up to the global financial crisis they wrote:

“It is difficult to recall a greater example of wishful thinking combined with hubris.”

Meanwhile, economist Paul Krugman asked a similar question – how did economists get it so wrong –  and came up with an answer to do with the difference between salt water and fresh water (apparently one turns you Keynsian and the other turns you neo-classical). Krugman noted the failure  of neoclassical economics to account for the apparent irrationality of the market, and proposed as a remedy the emerging sub-discipline of behavioural economics.

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly.

Both these approaches – that of the British Academy highlighting wishful thinking and hubris, and that of behavioural economics highlighting cognitive biases – make the great mistake of assuming that there is a single ‘ideal’ rationality,which real humans happen to be incapable of attaining. In other words the assumption that to be human is to have slipped off some kind of rationality ‘gold standard’ is wrong. To be sure, this is better than believing in the efficient markets hypothesis, with its implicit faith in rationality, and that in spite of all appearances,we’re still on the gold standard of rationality. But there is a better alternative to either neo-classicism or Krugman’s ‘flaws-and-frictions’ behavioural economics.

This alternative comes in  the shape of Gerd Gigerenzer’s rationality for mortals. Gigerenzer argues that ‘bounded rationality ‘ is not about optimisation under constraints, nor is it about ‘the study of errors’ (as suggested by Kahnemann, Slovic and Tversky’s 1982 analysis of cognitive bias). Instread he takes a positive view of cognitive biases and the use of heuristics. He argues these are aids to adaptive rationality rather than hindrances – they are effective and efficient cognitive short cuts that make us smart. Furthermore he argues that heuristics and biases are not rational or irrational in and of themselves, but only in relation to the environments in which they are being used. Everyone at all interested in this should read his essay ‘Striking a blow for sanity in theories about rationality’.

What Gigerenzer doesn’t do is to model the environment in reference to which rationality is to be judged. This is, in my view, where grid-group cultural theory can step in. It already has a typology of environmental structure, in which different sets of heuristics and biases are used to exploit different environments.

To summarise this in relation to economics, one might argue that the conventional debate in economics is between the Individualist neoclassicists and the Hierarchical Keynesians. The one puts trust in market-like transactions, the other in government intervention and regulation. Between them they fail to understand the contours of their own field and sytematically ignore the alternative rationalities of Fatalism on the one hand and Egalitarianism on the other. They fail because they steadfastly believe the particular environments in which they seem to work, and to which they may indeed be well suited, is the only possible environment.  They fail because they believe the only possible rationality is their own (Krugman provides a great example of this when he comments on the views of John Cochrane: ‘Personally, I think this is crazy’). The fatalist strand in economics is illustrated by the arguments of Nassim Taleb, who claims that the key failure in market rationality is to underestimate the caprice of the market. That leaves the Egalitarian strand of economics which, since it reeks of socialism, has tended to be sidelined over at least the past twenty years. But despite its smell, it offers a potentially useful way forward: since market failure on a massive scale is a big problem, one possible category of solutions might not be those which seek to reinstate the market (Individualist), to manage it (Hierarchy), or to become resigned to it (Fatalism), but those which seek to reduce the marketisation of life, to reduce the sheer significance of markets on our everyday lives. To the extent that markets are a) failing and b) unmanagable, the Egalitarian bias would say, let’s just try something else.

Note that if Individualist and hierarchical commentators were not expecting a credit crunch, both fatalist and egalitarian economics certainly were. Taleb’s strategy seems to have been to accept the dictum that markets can stay irrational longer than you can stay solvent and hedge against it. Note that he was not betting on markets being random, but on markets being more random than most investors believe them to be. Like the two men chased by a bear, he didn’t need to outrun the bear, only to outrun the other guy. The Egalitarian solution to market volatility is quite different: to try to avoid the market as much as possible. Grid-group cultural theory can identify these voices, and provide sound reasons why they should be heard. The answer to the Queen’s question of why no-one saw it coming is that some did, but they were systematically excluded from the discourse of economics. The answer to Krugman’s question about why economists got it so wrong is partly that they weren’t listening to the full range of views, and partly that they were laboouring, and are still labouring, under fatally flawed concepts of rationality.

Where will you go to next?

7 thoughts on “The financial crisis: Why did no-one see it coming, and why did economists get it so wrong?

  1. of course the other thing is with economists, is that he who pays the piper calls the tune, the consumer always thinks they ARE rational, try selling the purchase as insane and see how far you get

    1. Meika, I like the idea that you get the economics you pay for (I know I do…) and I’ve written some more on it here. Your comment made me wonder what causes university economics departments to splinter into different ‘schools’ of thought. Could some kind of economic model be worked out? If, as Krugman says, the split in the US is between freshwater and saltwater (coastal states versus inland states) that seems pretty arbitrary, but perhaps there is something in the funding arrangements of these universities that favours either neoclassical or Keynesian economics to dominate. Given that US universities often rely on private bequests and philanthropic grants, perhaps there is a preponderance of ‘liberal’ funding on the coasts and ‘conservative’ in the middle. Just guessing, though.

  2. So, a question arises, when, and in what circumstances (socially, culturally) does one (worldview bias) overcome the other (vested material interest) and vice-versa.

    Further, in the individual, when does either proclivity subsume itself in order to drive the other proclivity forward? (that ‘cognitive dissonance’ thingo at one extreme? material contradictions at the other??)

    How does the first more social question influence the second more individual question? And how is it that all those individual choices ‘pool’ into the social/cultural religious.

    [[[[And in terms of ‘bounded rationality’, how plastic is this boundary?]]]]

    Also, how do I con someone into paying me to research this? Surely a pool can be either salt or freshwater.

  3. >What Gigerenzer doesn’t do is to model the environment in reference to which rationality is to be judged.

    Actually, all the research projects carried out in Gigerenzer’s group do model environments and define rationality in relation to environmental structure. It’s their bread and butter, see the book Simple Heuristics That Make Us Smart in which scores of environments are modeled.

    The fit between a decision-making strategy and the environment is what Gigerenzer calls “ecological rationality”. See

    1. Thanks very much for clarifying that. What I should have written was “What Gigerenzer doesn’t do in Rationality for Mortals, but does do elsewhere is to model the environment in reference to which rationality is to be judged.” Thanks for providing the link.

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