Tag: rational behaviour

Should economists have foreseen the credit crunch? A few were warning of an overheated world economy with excessive credit and risk taking. Most economists prior to 2007/8, however, were predicting a continuation of steady economic growth. Inflation targeting, fiscal rules and increasingly flexible markets were the ingredients of this continuing prosperity. And then the crash happened!

So why did so few people see the downturn coming? Were the models used by economists fundamentally flawed, or was it simply a question of poor assumptions or poor data? Do we need a new way of modelling the economy, or is it simply a question of updating theories from the past? Should, for example, models become much more Keynesian? Should we abandon the new classical approach of assuming that markets are essentially good at pricing in risk and that herd behaviour will not be seriously destabilising?

The following podcast looks at these issues. “Aditya Chakrabortty’s joined in the studio by the Guardian’s economics editor Larry Elliott, as well as Roger Bootle, the managing director of Capital Economics, and political economist and John Maynard Keynes biographer Robert Skidelsky. Also in the podcast, we hear from Nobel prize-winning economist, Elinor Ostrom, Freakonomics author Steven Levitt, and UN advisor and developmental economist Daniel Gay.”

The Business: A crisis of economics Guardian podcast (25/11/09)

See also the following news items from the Sloman Economics news site:
Keynes is dead; long live Keynes (3/10/09)
Learning from history (3/10/09)
Macroeconomics – Crisis or what? (6/8/09)
The changing battle grounds of economics (27/7/09)
Repeat of the Great Depression – or learning the lessons from the past? (23/6/09)
Animal spirits (30/4/09)
Keynes – do we need him more than ever? (26/10/08)

Questions

  1. Why did most economists fail to predict the credit crunch and subsequent recession? Was it a problem with the models that were used or the data that was put into these models, or both?
  2. What was the Washington consensus? To what extent did this consensus contribute to the current recession?
  3. What is meant by systemic risk? How does this influence the usefulness of ‘micro’ financial models?
  4. What particular market failures were responsible for the credit crunch?
  5. What is meant by ‘rational behaviour’? Is it reasonable to assume that people are rational?
  6. Is macroeconomics too theoretical or too mathematical (or both)? If you think it is, how can macroeconomics be reformed to improve its explanatory and predictive power?
  7. Does a ‘really good economist’ need to have a good grounding in a range of social sciences and in economic history?

Whilst some economists predicted the banking crisis of 2007/8 and the subsequent global recession, many did not. Was this a failure of macroeconomics, or at least of certain macroeconomic schools of thought, such as New Classical economics? Or was it a failure to apply the subject with sufficient wisdom? Should the subject be radically rethought, or can it simply be amended to take into account aspects of behavioural economics and a better understanding of systemic risk?

The four linked articles below from The Economist look at the debate and at the whole state of macroeconomics. The other articles pick up some of the issues.

Will the ‘crisis in macroeconomics’ lead to a stronger subject, more able to explain economies in crisis and not just when they are working well? Will a new consensus emerge or will economists remain divided, not only about the correct analysis of how economies work at a macro level, but also about how to tackle crises such as the present recession?

What went wrong with economics The Economist (16/7/09)
The other-worldly philosophers The Economist (16/7/09)
Efficiency and beyond The Economist (16/7/09)
In defence of the dismal science The Economist (6/8/09)
How to rebuild a shamed subject Financial Times (5/8/09)
What is the point of economists? Financial Times – Arena (28/7/09)
Macroeconomic Models Wall Street Pit (23/7/09)
Macroeconomics: Economics is in crisis – it is time for a profound revamp Business Day (27/7/09)

Questions

  1. Distinguish between ‘freshwater’, ‘saltwater’ and ‘brackish’ macroeconomics.
  2. Explain why economists differ over the efficacy of fiscal policy in times of recession. To what extent does the debate hinge on the size of the multiplier?
  3. Why is the potential for macroeconomics higher now than prior to the recession?
  4. What is meant by the ‘efficient market hypothesis’? How did inefficiencies in financial markets contribute to the banking crisis and recession?
  5. Should economists predict the future, or should they confine themselves to explaining the present and past?

The following articles look at a recently published book by George Akerlof of the University of California, Berkeley, and Robert Shiller of Yale. They examine the role of what Keynes called ‘animal spirits’ and is the title of the book.

The motivation to make economic decisions (to buy, to sell, to invest, etc) may not be ‘rational’ in the sense of carefully weighing up marginal costs and marginal benefits. Rather it can be one of over-optimism in good times or over-pessimism in bad times. Just as individuals have ‘mood swings’, so there can be collective mood swings too. After all, confidence, or lack of it, is contagious. This motivation that drives people to action is what is meant by animal spirits.

But are animal spirits a blessing to be nurtured or a curse to be reined in? Should governments seek to constrain them?

An economic bestiary The Economist (26/3/09)
Good Government and Animal Spirits Wall Street Journal (23/4/09)
Irrational Exuberance New York Times (17/4/09)
Animal Spirits: A Q&A With George Akerlof Freakonomics: New York Times blog (30/4/09)

Questions

  1. Describe what is meant by ‘animal spirits’ and their effects on human behaviour.
  2. Why may animal spirits make economies less stable?
  3. How may animal spirits help to explain exchange rate overshooting?
  4. Discuss whether governments should seek to constrain animal spirits and make people more ‘rational’? Also consider what methods governments could/should use to do this?

In an earlier news item we saw that the global recession has hit the demand for organic produce. The same is not true for Fairtrade products as a global survey published on 17/4/09 shows (see). Awareness of Fairtrade products continues to grow as do sales. The articles below look at the findings of this survey and at the explanations behind it.

UK: Fairtrade Flows Against Economic Tide Namnews (20/4/09)
The government must act on fair trade now Public Service Review: International Development Issue 13 (20/4/09)
Fairtrade a hit with shoppers as demand rises despite credit crunch Glasgow Daily Record (17/4/09)
Link to short videos from the Fairtrade Foundation; Link to facts and figures on Fairtrade Fairtrade Foundation

Questions

  1. Consider the reasons why Fairtrade sales have increased while sales of organic produce have declined.
  2. Does purchasing Fairtrade products mean that consumers are not seeking to maximise their consumer surplus?
  3. What economic challenges face Fairtrade producers? How should governments help the Fairtrade movement?
  4. Is the liberalisation of trade in the interests of Fairtrade producers?

In the article below Tim Harford (the Undercover Economist) looks at rationality in the purchase of cigarettes. He consider whether healthy and happy smokers are the same thing and the extent to which smokers would be happier if cigarettes were more expensive.

Why smokers are happier when cigarettes cost more MSN Slate (17/5/08)

Questions

1. Identify the principal factors that determine the level of demand for cigarettes.
2. Given the factors identified in part (a), discuss the likely value of the price elasticity of demand for cigarettes.
3. Discuss the extent to which higher cigarette prices would make smokers happier.