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COMMENT: MONEY MATTERS
Economists 'blind to reality'
Economists ignored human factor in run-up to financial crisis, says Samah El-Shahat.
Last Modified: 03 Sep 2009 12:24 GMT

Samah El-Shahat, Al Jazeera's resident economist, writes a regular column analysing key events that contributed to the global financial downturn and its impact across the world.

 Why many economists failed to predict the financial crisis

The financial crisis has not only left economies and lives in a mess, it has also dealt the subject of economics a heavy blow. 

After all, economics has claimed since the 18th century that it should be treated as "predictive science", and yet it failed to do just that. It didn't "predict" the crisis.

Even the British monarch, Queen Elizabeth II, embarrassed an economist by asking at a recent party: "Why didn't you see the crisis coming?"

Yes, there were the few odd economists here and there, such as Nouriel Roubini, who predicted the crash.

But from the hundreds of thousand of mainstream economists, including Nobel Prize winning ones? Not a word, not a whimper, not a whisper about the looming crash ever parted their lips. 

So what went wrong? Economics itself did.

Out of touch

Economic theory has been so out of touch with the real world that one notable Nobel prize winning economist, Robert Shiller, recently wrote: "To a remarkable extent we have got into the current economic and financial crisis because of the wrong economic theory."

In a nutshell, standard economic theory inadequately explains how you and I behave.

"Mainstream economics is so wedded to the principle of free markets... it never allowed itself to consider it could all go wrong"

Samah El-Shahat

That's why economists couldn't foresee what banks, bankers and traders got up to and the crazy bets they took with our futures.

Mainstream economics is so wedded to the principle of free markets - that mix of  deregulation, free trade, trade liberalisation and small government which got us into this mess - it never allowed itself to consider it could all go wrong.

So it created assumptions, unrealistic ones, about how we behave. And those assumptions, conveniently, always suited the notion that market economies are perfect.

Mainstream economics assumed that people are mostly engaged in rationally calculating and maximising their self-interest.

Okay, so what does that mean? It means, mainstream economics assumed people were perfect, robot like in fact, and that we make decisions about how we should act, and what we should buy, by comparing the costs and benefits of different courses of action.

The selfish gene?

Moreover, mainstream economics assumed that if we all act selfishly, thinking only of our own interests, this would end up benefiting everyone.

Based on these bizarre tenets, standard economic theory constructed whole economic and financial models on which to design policies.

But tell me, please, when was the last time you thought like that when you went shopping or when choosing which film to watch?

Bankers and traders 'took crazy bets based on feelings of optimism', says El-Shahat [EPA]
If I am so rational, can someone please explain why I tend to buy more food when if I go supermarket shopping when hungry?

Or why, after a workout and an entire day of sensible eating, I binged on a chocolate bar last night. In the rational world there would be no yo-yo dieters. That counts me out.

Moreover, if we all acted selfishly, please also explain random acts of kindness toward strangers, such standing up on the bus to give an elderly person a seat or giving money to a charity.

But standard economic theory and its powerful followers adhere fervently to its unrealistic assumptions. And that is why when the crisis happened, it was a true shock to their system.

Recall Alan Greenspan's astonishment, for one. In his congressional testimony in late 2008 following the collapse of Lehman Brothers, he declared himself "shocked" that markets did not work as anticipated.

"I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms," he said.
 
So what was the crucial assumption human characteristic that was assumed away by standard economic theory?  That would be our emotions. Which is crazy – I know!

Panic and optimism

The one thing that makes us human are our irrational feelings, our imperfections, our flaws and our contradictions. 

The one thing this crisis has shown us is how emotions, and in particular extreme feelings that sway between panic and optimism, seem to have dictated what happened in the financial sector.

"Economists' refusal to truly incorporate real human behaviour - that we are irrational - has not only damaged the reputation of economics itself but it has damaged many lives globally"

Samah El-Shahat

Bankers and traders took crazy bets based on feeling of optimism and panic that had nothing to do with "rational" thinking. They weren't weighing up the merits of each transaction or the sub-prime mortgage derivatives they were buying or selling. 

In fact, we find out now, they never understood these derivatives in the first place, nor did they even know how to price them, so how could they have been "rational" when they bought them. 

They were following the pack, that is, they thought if everyone else was buying them, they must be good. They never did their due diligence or their homework, which is at complete odds with what economic theory would say.

And as Robert Shiller writes: "Standard economic theory failed to take into account that buyers and sellers of assets might not be taking due diligence, and the marketplace was not selling them insurance against risk in the complex securities they were buying, but was instead, selling them the financial equivalent of snake oil."

We have all paid a very high price for mainstream economists' sycophantic love affair with the market economy. What were theories in journals and economic publications, wrought real havoc into our lives.

Economists' refusal to truly incorporate real human behaviour - that we are irrational - has not only damaged the reputation of economics itself but it has damaged many lives globally.

Shiller is right, we did get into this mess because of a "wrong economic theory". 
 
Samah El-Shahat also presents Al Jazeera's People & Power programme.

The views expressed in the above column are the author's own and do not necessarily reflect Al Jazeera's editorial policy.

Source:
Al Jazeera
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