Behaviours, Not Rationality, Drive Markets

Peter Foster writes on “The dangers of behavioural economics” in Financial Post, Toronto (25 November) HERE about the alleged dangers of big bonuses on decision-making – apparently they are do not improve performace. (For the details, follow the link).

Peter Foster writes:

“What is perhaps most fascinating about the rise of behavioural economics is that it reminds us that “conventional” academic economics somehow became sundered from human nature. We might remember that 17 years before he published The Wealth of Nations, Adam Smith published The Theory of Moral Sentiments. Smith never for a second imagined that humans were rational calculating machines. Similarly, the greatest economists of the twentieth century — von Mises, Hayek, Schumpeter and Keynes — all regarded homo economicus as a nonsense. Keynes was the odd man out, however, because he believed in an even more fanciful construct — homo politicus — a brilliant individual motivated solely by the public good.

The power of the market meanwhile does not derive from human rationality but from the fact that it rewards or punishes commercial behaviour on the basis of its contribution to society. It is doling out a whole mess of punishment right now, despite the attempts of government to shove cushions down everybody’s shorts.

Man is fatally flawed and periodically subject to Extraordinary Popular Delusions and Madness of Crowds, but a far great delusion is that there is a political solution to his shortcomings.

Unfortunately, behavioural economics is regarded as a new tool with which our political masters might improve us. That is far more potentially damaging than the most elaborate of bonuses.”

Comment
On the whole I agree with Peter Foster in his disdain for the fanciful theories of Homo economicus and Homo politicus, because I am not too fond of the idea of human rationality driving all behaviour in the economic models common among modern economists, other than in the sense we can rationalize any decision into it being rational for that person in those circumstances.

The fad for ‘explaining’ why some (it’s always some, never all, though the obvious caveat is often ignored in the admiration of the ‘rationalist’ for the beauty of the alleged explanation) behaviour can be seen to be ‘rational’.

For instance, teenage girls becoming pregnant is supposedly a rational search to qualify from welfare payments (but why don’t all girls who might believe they would benefit from welfare become pregnant?), or teenage boys develop criminal tendencies to enhance their prestige among their peers (but why do so many more boys in the same circumstances of broken families, slums, unemployment and poor education, not become criminal recidivists?).

Of course a ‘rational’ explanation for these girls and boys not covered by the initial explanation can be advanced too on other grounds, but if every variation is ‘rational’ too then ‘rational’ is no longer the explanation. People do what they do because that’s what people do when they do whatever they do!

Markets are the net effect of all behaviours, not just rational ones. And many of these behaviours are not captured in the rational calculus. Adam Smith understood that truth.

Markets as Part of the Solution

The Foundation for Economic Education (FEE) publishes a daily email service with relevant stories from around the world. While not agreeing with everything it reports, I find little gems about the economic illiteracies of sections of rich world thinking.

Today’s FEE has one such gem:

“The best help for the poor is unrestricted market opportunity.
Nike Ends Labor Contract with Supplier Over Child Labor Concerns

"By severing its contract with Saga, Nike is likely to score moral points with its customers in the West. But it's also likely, observers agree, to sink Saga, a corporate giant that makes about 6 million of Pakistan's annual production of 40-million soccer balls. Saga estimates that as many as 20,000 families could be affected, since 70 percent of the local market relies on them for work." (Christian Science Monitor, Friday)

Comment
This kind of report always worries me. We want desperately to help the poor in the world to move from desperate poverty to opulence. We also have wage labour in our opulent economies much higher than in poor countries. Nike will ‘score moral points’ with the opulent families in rich countries for further reducing the living standards of thousands of already poor families in poor countries. But the rich folks won’t see that, except as famine victims when it’s too late to develop a market economy.

Development takes time. Markets are a long-term fix. Poverty is the consequence of a lack of markets. Smith expressed this clearly when he wrote about the income of the common labourer in the 18th century being higher than the income of labourers in the 17th century around the time of Charles II’s restoration, which were higher than the time of William the Conqueror in the 12th century, which, in turn, were higher than at the time when Caesar ‘visited’ Britain in 54 BC.

With globalisation we are not talking about it taking centuries to raise world living standards, but nor are we talking about decades. World markets are spreading fast enough to raise the incomes of 20,000 Pakistani families by the second or third generations. Interrupting economic growth is not part of the process.

If the ‘moral’ urge in rich, protectionist countries is to undertake development in poor countries as fast as possible, the energies of the rich moralists should be directed at reducing protectionist barriers against agricultural and manufacturing produce of the poor countries.

Nike is not part of the problem; it is part of the solution. So those with heavy moral boots should tread carefully. They could start, for example, by lifting tariffs on footwear, underwear, and such like from poor countries, which would do much to expand production facilities in poor countries and by increasing demand for labour, raise their wages and allow them to keep their jobs.

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Dr Drummond's Students in Good (but not invisible) Hands

Accounts of markets are always interesting to economists, especially those emerging markets which are in transition from simplicity to complexity. Economic development, as in China, tracks the emergence of markets from within the statist society that was communism.

Dr Drummond provides an excellent example of the genre, reporting on his stay in BeiBei (in connection with an academic exchange visit). I quote the opening paragraphs and strongly recommend that you read the whole piece at:
http://drummondinbeibei.blogspot.com/ :

“Markets
Adam Smith, generally considered to be the father of economic thought, was mystified by the operation of markets. How could they be so efficient without some sort of managerial oversight? Smith concluded that markets were coordinated by the “propensity in human nature…to truck, barter, and exchange.” That is, to engage in commerce is just as much a part of the human experience as to engage in survival or reproduction.
Each Thanksgiving we celebrate the bountiful harvest of almost 500 years ago when the first successful colonists arrived in the “new” world. As I walk the streets of Beibei [China], I frequently wonder what it looked like five thousand years ago as the early inhabitants of this river valley pursued their “propensity…to truck, barter, and exchange.” My initial guess is that not much has changed.”

Comment
What follows is fairly modern Adam Smith, without it being overtly so. When I read the first paragraph I thought it was about to burst into praise of the invisible hand fable, but my heart lifted when it raised the truly Smithian idea of ‘truck, barter and exchange’.

The closer you get to real markets with real people, and away from the abstractions of so-called general equilibrium neo-classicism, the less likely you will fall into the stupor of belief in mystical or miraculous invisible hands (which have nothing to do with Smith’s theories of markets).

Dr Drummond’s students are in good hands.