Reflections at the Intersection of Economy & Society: The Science of Economic Bubbles and Busts

Monday, June 22, 2009

The Science of Economic Bubbles and Busts

It is great to see the new trend in economics--behavioral economics, finance economics, and neuroeconomics--away from classical economic theory to an investigation of the role of psychology in making economic decisions. What is next? An investigation of the role of socal structure and cultural schemes in economic markets:) I hope you enjoy the following article and I look forward to any reaction.

Gary Stix--Even people who do not use illicit drugs or get shot in the head have to contend with the reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.

The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

Economists have fought for decades about whether money illusion and, more generally, the influence of irrationality on economic transactions are themselves illusory. Milton Friedman, the renowned monetary theorist, postulated that consumers and employers remain undeluded and, as rational beings, take inflation into account when making purchases or paying wages. In other words, they are good judges of the real value of a good.

But the ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast. And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the VMPFC and other brain areas. Notably, an experiment reported in March in the Proceedings of the National Academy of Sciences USA by researchers at the University of Bonn in Germany and the California Institute of Technology demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well. (more)

If you like this, then here are a few books you should read:

Shiller, Robert. 2008. The Subprime Solution: How Today's Global Financial Crisis Happened and What to DO about It. Princeton University Press.

Akerlof, George A., and Robert Shiller. 2009. Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Princeton University Press.

Thaler, Richard H., and Cass Sunstein. 2009. Nudge: Improving Decisions about Health, Wealth and Happiness. Penguin Books.

Ariely, Dan. 2008. Predictably Irrational: The Hidden Forces That Shape Our Decisions. HarperCollins.

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Economy & Society Quotes:

"The central characteristic of agents is not that they reason poorly but that they often act intuitively. And the behavior of these agents is not guided by what they are able to compute, but by what they happen to see at a particular moment." -Daniel Kahneman

"The problem is a lot of what is called economics is not economics. It is more ideology or religion." - Joseph Stiglitz

"Formal rules are an important part of the institutional framework but only a part. To work effectively they must be complemented by informal constraints (conventions, norms of behavior) that supplement them and reduce enforcement costs." -Douglas North

"The science called 'economics' is based on an initial act of abstraction that consists in dissociating a particular category of practices, or a particular dimension of all practice, from the social order in which all human practice is immersed." -Pierre Bourdieu

"Rational economic man, in the narrow mainstream sense, is close to being a social moron. The inability to think about other people is not a proof of reason - it's the absence of reason." -Amartya Sen

"It is not the consciousness of men that determines their being, but, on the contrary, their social being that determines their consciousness." -Karl Marx

"Actors do not behave or decide as atoms outside a social context, nor do they adhere slavishly to a script written for them by the particular intersection of social categories that they happen to occupy. Their attempts at purposive action are instead embedded in concrete, ongoing systems of social relations." -Mark Granovetter

"Once a transaction has been made, in which the principal satisfies interests of the agent (for example, through a monetary payment) in return for the agent's using his actions to pursue the principal's interests, a social system has been created." -James Coleman

"Given the fact that economists and sociologists each hold half of the truth, so to speak, when it comes to markets, it seems natural that they should try to coordinate their efforts. Economists need to better understand the role of the social relations in the market, and sociologists need to better understand how prices are formed and what effect these have on the economy." -Richard Swedberg

"My aim is to integrate a focus on social relations and institutions into a modern sociological approach to the study of economic behavior by highlighting the mechanisms that regulate the manner in which formal elements of institutional structures in combination with informal social organization and networks and norms facilitate, motivate, and govern economic action." -Victor Nee

“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” -John Maynard Keynes

"The more people accept the neoclassical paradigm as a guide for their behavior, the more their ability to sustain a market economy is undermined." -Amitai Etzioni

"The great bulk of controls over social behavior are not external but built into the relationships themselves." -George Homans

"While economics is about how people make choice, sociology is about how they don't have any choice to make." -Bertrand Russell

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it." -Upton Sinclair

"It takes centuries of culture to produce a utilitarian such as John Stuart Mill." -Henri Bergson

"The contract is not sufficient by itself, but is only possible because of the regulation of contracts, which is social in origin." -Emile Durkheim

"The care for external goods should only lie on the shoulders of the ’saint like a light cloak, which can be thrown aside at any moment.’ But fate decreed that the cloak should become an iron cage.” -Max Weber

"A hardhitting economic sociology would attempt to draw on the best of sociology and economics, and to unite interests and social relations in one and the same analysis. Interests, in all brevity, are always socially defined, and they can only be realized through social relations." -Richard Swedberg

"As economic sociology moves beyond the earlier embeddedness perspective, the challenge is to specify and explicate the social mechanisms determining the relationship between the informal social organization of close-knit groups and the formal rules of institutional structures monitored and enforced by organizations and states." -Victor Nee

"I had stumbled on one of the fundamental truths of economics that no one in graduate school had ever told me about: If you want markets to expand, you need governments to do the same." -Dani Rodrik

"When the facts change, I change my opinion. What do you do, sir?" -John Maynard Keynes

"The difference between the most dissimilar characters, between a philosopher and a common street porter seems to arise not so much from nature, as from habit, custom, and education." -Adam Smith

“The businessman is only tolerable so long as his gains can be held to bear some relation to what, roughly and in some sense, his activities have contributed to society.” -John Maynard Keynes

"Markets are most developed and most effective in generating wealth when they are backed by solid governmental institutions. Markets and states are complements, not substitutes, as simplistic economic accounts would often have it." -Dani Rodrik

"Social relations, rather than institutional arrangements or generalized morality (e.g. shared beliefs and norms), are mainly responsible for the production of trust in economic life." -Mark Granovetter

"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." -John Maynard Keynes

Monday, June 22, 2009

The Science of Economic Bubbles and Busts

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