Economic psychology as a new sub-discipline of economics had gained considerable ground since John Maynard Keynes and the founding of rational expectations in neoclassical economics. Even the “Morning in America” president Ronald Reagan had embraced sharp witticism to describe recessions and depressions in purely psychological terms to defeat Jimmy Carter in 1980.
Economics, however, has always been about human behavior. Not economic behavior, but human behavior. The problem has been with the behavioral assumptions. Most fundamental of them being that self-interest is rational behavior. Indeed it is. The trick of deciphering enlightenment economics is what does the phrase “self-interest” mean for it to be rational in terms of Adam Smith?
Keynes, whose stated purpose was to overturn pure classical economics (though I would contend that he had cleverly saved Adam Smith from Karl Marx by introducing stabilization policy into economic theory), had dwelled on psychology by explaining the type of behavior during the Great Depression and before which causes economic cycles as animal spirits. But are animal spirits necessarily irrational behaviors? Does the phrase ‘rational expectations’ mean human behavior devoid of emotion and driven by purely calculated logical thinking? Are emotions not reason? Is instinctive animal behavior not reason, but of a far more biologically limited cognitive capacity, to achieve the same ends as those of the human species such as food, shelter, reproduction and self-defense?
It can be argued that human beings continue to exist solely by the luck of mutation since the FOXP2 genetic mutation about 50,000 years ago that endowed us with language or behavioral modernity, the basis of all higher-level cognitive capacities to enable the species to reflect on its instincts to modulate urges and to shape its environment to ensure continued survival. And perhaps, that modulating instinctive urges was necessary to enable influencing the living environment, also known as technical change, to bring about relatively settled living conditions out of nomadism.
So, the animal spirits of Keynes are about the incapacity of financial markets participants to reflect on their instinctive, heuristic urges to buy and sell: the absence of conscious hermeneutics. They are correct for example when oil and food prices rise reflecting the expected underlying scarcity of those goods, but at the same time the response could be exaggerated even though the outcome of that response which captures the popular imagination is bonus payments. Similarly, the response to the housing crisis was just as rational but exaggerated. The political question though is if such behaviors are being deliberately orchestrated.
This inability to reflect is perhaps a response to not having to survive because there are no external constraints to force such self-reflection as a day-to-day matter for traders and because traders are not intellectuals. Therefore, the lack of self-reflection renders the self-interest unenlightened and hence, is entirely inconsistent with Adam Smith until the average social consciousness in the society is itself elevated to a higher-level of thinking. The unquestioned belief that the natural cycle of the economy is unavoidable is itself a constraint, because after all, it is all human activity varying only in scale.
Enlightenment could indeed set in in the classical long run, when unenlightened behaviors affect the pocket book adversely and persistently to make the best of what they have, leading to technical change and new exuberance. But the pent up demand for a better life makes the enlightenment ephemeral, continuing the cycle of exuberance and fear and boom and bust. Perversely, the dearth of money can cause technical change by raising the efficiency of money supply, the trade-off being some suffering in the immediate to medium terms, because it is difficult to determine the optimal amount of money supply for economic growth without risking its misallocation in the absence of real innovation which could put off market clearing some more by introducing inertias that did not hitherto exist.
The reality of the crises since October 1987, however, is that the financial markets have figured out how to insulate themselves from the boom and bust but pass on the suffering as a negative externality of the business cycle to someone else down the income ladder and the government let it happen. The cyclicality itself has turned into a policy tool rather than being subject to it due to exogenous factors since Keynes. Then does it mean that the dichotomy between Keynesian stabilization policy and classicism cannot be erased and that societies must choose between one or the other?
That is not necessarily the case though the answer may not be New Keynesian Economics. The problem definition is to align short run Keynesian policies with the long run natural tendency of the markets to clear to hasten market clearing, by shrinking the time horizon itself through the structural stabilization of the business cycle or the cycles of technical change by restructuring both how government intervenes in the markets and how the financial markets are themselves structured. They can neither be left to Adam Smith’s classical long run nor to Joseph Schumpeter’s moods or to the people’s kinship with their work as it appears Akerlof and Kranton are arguing.
Economic activity changes by nature with overarching paradigms of technical change as described by Thomas Kuhn in the Structure of Scientific Revolutions and people take pride in what they do within the contexts of those paradigms and changing those paradigms must happen with the least disruption. Hence, the indispensable enlightened role of the social elites. The more the spread of enlightened ways of thinking in a society the greater are the chances of species perpetuity, barring catastrophes (data does not validate the Romer model of endogenization of technical change because human capital as measured by the number of years of formal education even in the best of today’s educational institutions does not necessarily correlate well to enlightenment).
Until then, “Morning in America” may change the mood but that rhetoric may not be credible.