So, I'm here in my new old hat as a financial and political advisor. And I was thinking to myself, 26 years in the field of psychology, another 20 years in finance and politics and so on and so forth, why not combine the worst of the two worlds?
Why not discuss the psychology of economics and finance?
It's a field known as behavioural economics, which is gaining traction and recognition all over the world.
Some of its proponents have won Nobel Prizes in the preceding two decades.
I've been advocating, ever since I remember myself, that economics is not a science. It's a branch of psychology.
And in this sense, it's a descriptive taxonomy of human behaviors.
Economists observe humans, then they describe their behaviors and they connect the dots sometimes or very often actually using mathematical models.
But using a certain language known as mathematics and describing the behaviors of certain populations or even individuals, that's not a science. That's no more a science than botany was when Linius started it 250 years ago.
So, before we delve in, I want to read to you something that Ludwig von Mises has written.
It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.
But Ludwig von Mises was saying actually, it's impossible to describe any human action if you ignore psychology.
Economics to the great dismay of many economists is merely a branch of psychology. Economics deals with individual behavior and with mass behavior and behaviors are human attributes.
Humans behave, at least economically.
I have yet to see a chimpanzee with a credit card or a dog with a mortgage.
Humans are the only ones who engage in advanced, sophisticated and complex economic behavior.
Many of the practitioners of economics seek to disguise its nature as a social scienceand they do this the same way psychologists do.
They apply complex mathematics where common sense and direct experimentation would have yielded far better results.
And the outcome of all this camouflage is an embarrassing divorce between economic theory and its subjects with the people.
The economic actor in economic theory is supposed to be constantly engaged in the rational pursuit of self-interest.
The economic actor, the player, the economic agent is busy all the time maximizing his benefits, his income, his profits, pursuing his self-interestetc.
And he does this rationally, totally, objectively.
Of course this is rank nonsense. This is absolutely counterfactual.
That's not how humans behave. This is not a realistic model. It's merely a useful approximationand mind youa flattering one, we all would like to consider ourselvesrational agents or rational actorseven if we rarely are.
And so according to this latter dayrational version of the dismal science, dismal science is another name for economics.
So according to this approach to economicspeople refrain from repeating their mistakes. And systematically people seek to optimise their preferences.
Altruismfor examplecan be such a preferenceand that's why people engage in altruismand there's a forest of complex mathematical formula which seek to explain why people donate to charity, tax benefits and write-offs aside.
We like to believe, all of us like to believethat we are rational. We like to believe that we make sense, that our actions and inaction are imbued with meaning.
And such self-perception is egosyntonic. It makes us feel comfortable in our own skins, makes us feel even flattered.
There's a bit of grandiosity there, yes the truth isof coursethat many people are irrational or non-rational or nearly rational in certain situationsand the definition of self-interest as the pursuit of the fulfilment of preferences is a tautology. It's just saying the same thing using different words. It's meaningless.
It's not a real definition.
Unfortunate rationality is more like it. We're going to come and discuss it a bit later.
Most economic theories fail to predict important phenomena such as strong reciprocity, the propensity to irrationally sacrifice resources in order to reward forthcoming collaborators and punish free riders.
Different economic theories, most of them, not all of them, but most of them fail to account for simpler forms of apparent selflessness.
What about reciprocal altruism motivated by hopes of reciprocal benevolent treatment in the future?
All these fall outside the remit of rigid, classic economics and even monetary economics.
Another inflationfor example.
Inflation is a universal regressive tax.
When the value of your money depreciates, when your money can buy less and less, it's a tax.
It's exactly like a tax.
When you pay taxes, you have less money left to buy things with.
When there's inflation, you have the same amount of moneybut you can buy fewer things.
So inflation is a tax.
It is a regressive, a regressive universal tax.
Everyone rich and poor end up being subjected to the same rate of inflation.
Inflation facilitatesthougha transfer of wealth from the poor to the rich and from the poor to the state.
Inflation inflates. Asset values and rich people have many assets.
So the value of their assets increases.
Talking about stocks, real estate, bubbles, asset bubbles.
Inflation also erodes the obligations of the state and the value of unilateral transferssuch as social security payments.
So you get the same amount of moneybut it's worth less.
Inflation is the rich man's friend and the state's friend and the enemy of the poor.
But inflation involves cognitive distortions and cognitive biasessuch as catastrophizing.
"Oh my god, prices are going to go up tomorrow. I should buy things now."
Both inflation and its mirror image deflation.
In both cases, individual behavior may be rationalbut collective action, mass behavior, definitely is notbecause collectivelywe bring about inflation by purchasing everything now.
We create aggregate demand that pushes prices up.
And collectively, when there is deflation, when prices are going down rather than up, we postpone purchases. We postpone consumption.
And by doing this, of course, we create a recession or even a depression and prices go down even more.
Our irrational collective behavior brings about the worst economic nightmares we fear.
And yet none of this, catastrophizing, irrational collective action, cognitive dissonances, cognitive distortions, cognitive biases, defense mechanisms, none of these are mentioned in economic literature.
These are the main drivers and engines of economic decision makingand yet they're nowhere to be seen.
No student of economics studies any of this. It's not to be found in any textbook.
Even the authoritative and mainstream handbook of experimental economics by John Hegel and Alvin Roth, even this book admits that people do not behave in accordance with the predictions of basic economic theories.
Standard theory of utility, theory of general equilibrium, they are nonsense. They're not realistic. They're counterfactual.
And yet these are the pillars of modern economics.
Modern economics is delusional, fantastic, anything but real or helpful or useful.
Irritatingly for economies, people change their preferences mysteriously and irrationally.
And this is called preference reversals.
Economists are really pissed off at people for not conforming to their models.
The models are right and true. Something's wrong with people.
Moreover, people's preferences as evidenced by their choices and decisions in carefully controlled experiments are inconsistent.
There is a replicability crisis in economics.
We can't repeat most of the experiments and get the same results.
People tend to lose control of their actions or they tend to procrastinate because they place greater importance, a greater weight on the present and the near future than on the far future.
And this makes most people both irrational and unpredictable.
Because if you're so nearsighted, if your horizon is so short term, you are incapable of rationally planning for the far future and your behavior is bound to be erratic.
Either one cannot design an experiment to rigorously and validly test theorems and conjectures in economics.
Maybe there's a design problem or much more likely something is very flawed with intellectual pillars and models and pivots of this entire field.
In short, economics sucks.
Finally, what is rational on the level of the individual consumer or household or firm may be detrimentally irrational as far as the welfare of the collective goes.
I mentioned inflation and deflation earlier.
Take for example the famous thrift-thrift paradox.
It's a case in point.
In times of crisis, it makes sense to consume less and save more if you are a household or firm.
Most people and companies save more, invest less and consume less which makes the situation even worse.
The recession becomes depression.
The good of the economy as a whole requires you to act irrationally in such situations.
If you want to help your country and your nation and your community, you need to save less and you need to go on frequent shopping or retail sprees, retail therapy.
As an individual, you should save more and consume less when there's an economic crisis, in recession, in a recession for example.
But if you value your collective and you want to help your community, you need to do exactly the opposite.
You need to behave irrationally.
Neoclassical economics has failed on several fronts simultaneously and this multiple failure led to despair and to the re-examination of basic pursuits and tenets and in the longer run to the rise of behavioral economics.
I have a video dedicated to behavioral economics on this channel. It discusses the psychology of sales.
Consider this example of outstanding issues.
Unlike other economic actors and agents, governments are accorded a special status. They receive special treatment in economic theory.
Governments are not like other agents.
Government is alternatively cast as a saint, a savior of lost resort, seeking to selflessly maximize social welfare.
Or in other economic theories, the government is the villain. The state seeks to perpetuate and increase its power ruthlessly and callously.
These are known as public choice theories.
Both views are unreal and untrue. Both are caricatures of reality.
Of course, governments seek to perpetuate their clout and to increase it, especially in democratically elected countries where public opinion matters.
But governments also do so mostly in order to redistribute income to the poor.
It's rarely for self enrichment.
They are of course corrupt individuals, but governments as a whole are corrupt in very few places.
In most places, they are doing their best to balance scarce resources with social and economic priorities.
Governments' bad reputation is often justified.
Don't misunderstand me.
In imperfect or failing systems, a variety of actors and agents make arbitrage profits. They seek rents off the public purse. They use taxpayers' money to enrich themselves. They accrue income derived from facilitation, brokerage, mediation, and other venally rendered services.
But this is imperfect or failing systems, or systems in transition, or systems in crisis.
Not only do these functionaries lack motivation to improve the dysfunctional system that so benefits them. They have every reason in the world to obstruct efforts at reform and block fundamental changes aimed at rendering the system more efficient.
And all this is true.
But these are outliers. These are extreme cases.
This is not how governments mostly function.
We have cases of privatization where the private sector was much less efficient in governments at certain things, for example, utilities. Hospitals. Prisons.
Economics also failed until recently to account for the role of innovation in growth and development. The discipline often ignored the specific nature of knowledge industries and currently the attention economy.
In these industries, returns increase rather than diminish. Network effects prevail.
And so current economic thinking is industrial or even agricultural. It's 18th century thinking. It's woefully inadequate to deal with information monopolies, path dependence, pervasive externalities.
Don't ask. Look it up.
Classic cost to benefit analysis failed to tackle very long term investment horizons and periods.
The underlying assumption is the opportunity cost of delayed consumption.
If I don't consume now, I have money and then I can use this money to invest so that I'll be able to consume more in the future when I generate profits. And this is the opportunity cost of delayed consumption.
But this underlying assumption fails when it is applied beyond the investor's useful economic life expectancy.
People care less about their grandchildren's future than about their own.
This is because predictions concerned with the far future are highly uncertain and investors refuse to base current decisions on fuzzy what ifs, what if scenarios.
And this is a problem because many current investments such as, I don't know, the fight against global warming or climate change, these investments are likely to yield results only decades hence maybe in a century. And there's no effective method of cost benefit analysis applicable to such time horizons.
In short, economics, almost all the theories in economics, definitely also behavioral economics, they're all short term. They cannot account for coordinated globalized efforts with an economic nature such as fighting climate change or investing in very long term infrastructure or financing innovation which will mature and yield any outcomes, any perceivable economic outcomes 50 years from now.
And these theories don't deal well with these situations because they are based on very primitive short term thinking.
How are consumer choices influenced by advertising?
What Louis Althusser called interpolation? What about pricing? Maybe it will not, shocking as it may sound, no one has a clear answer. No one knows.
Yes, of course we have the famous graph where demand and supply and how prices affect demand and supply, the equilibrium points and all this.
This is a myth. This is a myth. It's not real. It's an obstruction, an idealization.
Advertising does have an effect. What about, but it's not the one described in economic models.
Advertising has an effect. It shifts the demand in highly specific ways.
Uncertainty has an effect. Externalities have an effect.
First mover advantages have effects. Innovation has effects. Fashion and fads have effects.
How many effects that are nowhere to be seen in economic theories?
Poverty, I mean nowhere to be seen. No one seems to have clear answers and models which we would recognize instantly as layman consumers, layman investors, layman households.
Economics is so divorced from daily experience that it might as well be referring to another planet.
Advertising is concerned with the dissemination of information for example, but it's also a signal. It's a signal sent to consumers that a certain product is useful and qualitative and that the advertiser's stability, longevity and profitability are secure.
If a company has enough money to invest in advertising, it can be trusted to survive until it delivers the product. It communicates a long-term commitment to a winning product by a firm with deep pockets.
This is why patrons react to the level of visual exposure to advertising regardless of its content. This is only one example.
The problem of economics is the problem of psychology and perhaps the problem of all social sciences.
The raw material, the subject, human beings. Human beings are too multidimensional, too hyper complex, too mutable. They change all the time. They change even in reaction to a study.
Human beings cannot be usefully captured by economic models or econometric models. These models and economic theories either lack predictive powers or lapse into logical fallacies such as the omitted variable bias or reverse causality.
Omitted variable bias is when important variables remain unaccounted for in a model.
But the reverse causality problem is reciprocal causation when every cause is caused by its own effect.
The fact that we are still arguing about all these issues, the fact that we are still getting things catastrophically wrong, except when it comes to very basic issues.
For example, you print a lot of money, you're going to have inflation. You raise interest rates, you're going to suppress consumption and investment.
Okay, big deal. Why do you need to study seven years to get this straight?
My grandmother knew this.
So with the exception of such tried trivial sentences, economics doesn't offer any shockingamazing insights into reality.
It's an all pervasive malaise.
Economists are simply not sure what precisely constitutes the subject matter.
Is economics about the construction and testing of models in accordance with certain basic assumptionsor should economics revolve around the mining of data for emerging patterns, rules and laws?
And these rules and laws, are they like rules of natureor are they subject to change at the moment's notice and the drop of a coin on a dime?
On the one hand, patterns based on limited or worse, non-recurrent sets of data from a questionable foundation of any kind of science.
This is not rigorousness. This is not methodology. This is not a scientific method.
When you mine data and you place it in beautiful mathematical models with very impressive equations, that's not doing science. That's not what science is all about.
So I repeatpatterns based on limited or non-recurrent sets of data. This is questionable science.
On the other hand, models based on assumptions are also endowed because they are bound to be replaced by new models with new hopefully improved assumptions in due time.
And this is not the same as replacing one the Newtonian theory in physics with Einstein's theory. It's not the same because both Newton and Einstein were referring to the same template, to the same raw material.
But in economics, we transition from one theory to another as if we were discussing different species.
One way around disappearing Wegmar is to put or introduce human cognition, psychology, and human emotions at the heart of economics, not as a veneer, not as polish, not as a coat of paint, but as the engine that drives economics.
Humans, their hopes, fears, preferences, priorities, wishes, dreams, plans, irrationality, crazy-making, defense mechanisms, cognitive distortions, cognitive biases, prejudices, upbringing, cultural context, social context, this and only this should be the heart and the engine and the pivot and the pillar and the axis of economics.
Assuming that being human is an immutable and knowable constant, this is, that should be amenable to scientific treatment.
So if we pretend that humans are objects subject to laws of inertia or I don't know, laws of nature of some kind, laws of the economic universe, it's not going to work because it's not true.
So we need to delve into the core of what it is to be human and begin to build models and theories around this, not in opposition to this.
Prospect theory, bounded rationality theories, the study of hindsight bias, other cognitive deficiencies or distortions, these are the outcomes of this budding approach in economics.
More and more economics is converging with psychology. In a way, economics is an affinity with some private languages. It is a form of art or literature and as such it is self-sufficient and self-contained. Its self-referentialeconomic theories discuss economic theories which discuss economic variables which come out or emanate or hail from economic theories which are about other economic theories.
It's a closed universe, as I said, self-referential, very often tautological.
If certain structural internal constraints and requirements are met, a statement in economics is deemed to be true even if it does not satisfy anything in the real world, even if it doesn't meet external scientific requirements. If a statement in economics sits well and validates other statements, it's considered to be true for some mysterious and bizarre reason.
So the standard theory of utility, for example, is considered valid in economics despite overwhelming empirical evidence to the contrary.
Why?
Because it is aesthetic and mathematically convenient and is on good terms with other nonsense in economics.
So what are economic theories?
What are they good for?
Why do we need them?
Economic theories and narratives offer an organizing principle, a sense of order, predictability, justice, determinacy, certainty, meaning.
Economic theories and narratives postulate an inexorable drive toward greater welfare and utility, the idea of progress.
In short, economic theories are ideologies in disguise.
Economic theories render our chaotic world meaningful, make us feel part of a larger whole in transition towards something desirable.
Economics strives to answer the whys and the hows of our daily life.
It is dialogic and prescriptive. It provides behavioral prescriptions.
In certain ways, economic theories are religion, a form of religion.
In the catechism of economics, the believer, for example, a politician or the head of a central bank, the believer asks why and here follows an economic problem or an economic behavior.
Why do people consume more when there's inflation?
So there's a question here.
Why?
The economist answers the situation is like this, not because the world is whimsical or cruel, irrational, arbitrary, and unpredictable and uncertain.
No, not because of any of this.
The situation is the way it is becauseand here there's a model, an economic model or a causal explanation based on an economic model.
And then the economist says, but if you were to do this or refrain from doing this prescription and proscription, if you were to behave in a certain way or to refrain from behaving in a certain way, then the situation is bound to improve.
The believer in economics, because it's a faith, the believer in economics feels reassured by this explanation and by the explicit affirmation that there is hope, hope providing he follows the prescribed guidance, his belief, the believer, the believer's belief in the existence of linear order, justice, structure administered by some supreme transcendental principleswhich are like laws of nature.
This belief is restored.
Economics pretends to be physics. The physics of money, the physics of wealth, the physics of scarcity, the physics of assets and liabilitiespretends to be physics.
Of course it's not, but the believers in economics pretend together with it that it is physics.
The believers in economics proclaim the rules of economics or the laws of economics or more precisely the mathematical models of economics to be the exact equivalent of gravity.
Gravity, it's an objective thing out there. All you have to do is find it out, study it and then follow the inevitable prescriptive behaviors.
This sense of law and order is further enhanced when the theory yields predictions which come trueeither because they are self-fulfilling or because some real law or pattern has emerged.
Alas, this happens very rarelyand againI'm not talking about grandmother's wisdom.
If you print money, its value goes down. If you increase interest rates, people will consume less. Big deal. You don't need a degree for this.
I'm talking about more profound alleged insights and discoveries in economics. They rarely work.
Economics utterly sucks when it comes to predictions, falsifiable predictions and verifiable predictions, deductively and inductively. It's not a science. If this is the test, falsifiability, it's not a science.
As nothing less than the economists, the economists noted gloomily, economies have the most disheartening record of failed predictions and prescriptions.
That's not Sam Vaknin, that's the economist.
So what are some of the major problems that economics faces today?
Neoclassical economics, as I said, has failed on several fronts simultaneously. This multiple failure led to despair and the re-examination of basic percepts, tenets and issues.
And I'll delineate nine of them because I couldn't find ten. I could find a hundred actually, but I'll delineate nine.
Let's start with government. We mentioned it before. Government was accorded a special status and a special treatment in economic theory, unlike other actors and agents. And I explained it before.
And government, the status of government or the role of government is yet to be properly defined.
There are ideological clashes between economists, which is a surefire proof that economics is not a science.
So some economists think that the government's role should be minimized because it is inefficient at allocating scarce resources. Others say that governments are the only one who can rectify market failures and provide afford regulation to ensure competition and the smoothfrictionless action of free markets.
Consider technology and innovation. Economics fail to account for the role of innovation in growth and development. And I mentioned that before also. And this is another topic, another area where disruption brought on by innovation actually leads to growth contrary to many economic theories.
And then there's the issue of longterm investment horizons that I mentioned.
How do we deal with investments, economic enterprises that span decades and centuries?
For example, the construction of a cathedral in the Middle Ages, which took sometimes four to six hundred years. It's an economic activity. Who can argue with it? It's a manifest economic activity, but it cannot be accounted for by any economic model or theory.
Or more economic is the problem.
This assumption that the economic agent is rational. Consumer choices are irrational in most cases. And even investment choices, which are supposed to be vetted by committees and experts and scientists and analysts, even investment choices are driven by egos or by fears or by catastrophizing or by lack of opportunity or by lack of options.
People don't behave in accordance with the predictions of basic economic theory. They just don't.
And we need to accept this and we need to accept also time inconsistencies. People tend to lose control of their actions, as I said, change their preferences suddenly.
There's a question of positivism via pragmatism. What should economics be focused on? The construction and testing of models, which are consistent with some basic assumptions, or should it revolve around mining data?
And I think the solution is to convert economics to a branch of psychology. Econometrics is the subbranch of economics known as econometrics, measuring, modeling, testing, mathematics. It serves to camouflage, it serves to disguise the inadequacies and shortcomings in economics as it stands today, almost in all its branches, even behavioral economies.
We need to start from scratch. We need to start from zero. We need to start from the raw material, from the subject matter. We need to start from us human beings, frail, unpredictable, crazy making. People don't act rationally, almost ever. Luckily for us, actually.
Thank you.