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Descartes Caused the Economic Collapse! April 29, 2009

Posted by Dwight Furrow in Current Events, Dwight Furrow's Posts, Philosophy.
Tags: , , ,

The economic meltdown was certainly caused by excessive greed and the absence of government regulation to contain it. But it is important to remember that there is a reason why few of the people trained to anticipate economic problems saw this coming.

John Kay in the Financial Times writes:

Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour…

This sounds reasonable—if you want to develop a theory of how economic institutions function, look at how individuals make decisions about buying and selling. Kay continues:

Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that.

By “rigorous” Kay means that economic relationships can be described by algorithms which are amenable to logical proof. (Descartes was perhaps the first philosopher to argue that only such a system could count as genuine knowledge, and his insight has deeply influenced scientific and social scientific inquiry to this day.)

But here is the rub. If you are going to describe economic relationships using algorithms (i.e. rules) you will have to make generalizations about human behavior.

Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency. Any other theory would have to account for the evolution of individual beliefs and the advance of human knowledge, and no one imagines that there could be a single theory of all human behaviour…

In other words, even though human beings are often rational and, in market transactions, we often get exactly what we want for exactly the right price, the myriad ways in which we can fail to be rational or efficient is just too complex to model, especially when you consider the value we place on non-market goods. No set of rules could describe every twist and turn in the history of the market behavior of individuals or account for our quirky, idiosyncratic, emotional, intuitive, and sometimes irrational behavior. Thus, economic models assume that human beings are always perfectly rational and markets perfectly efficient.

As Kay writes:

That people respond rationally to incentives, and that market prices incorporate information about the world, are not terrible assumptions. But they are not universal truths either. Much of what creates profit opportunities and causes instability in the global economy results from the failure of these assumptions. Herd behaviour, asset mispricing and grossly imperfect information have led us to where we are today.

It was irrational behavior, left out of the economic models because it was too messy to capture in a set of rules, that caused the economic crisis.

Descartes has not yet issued his mea culpa.

So why did these very smart people fail to realize that their generalizations were rough approximations rather than precise models of human behavior.

Kay appeals to the mid-20th Century economist John Maynard Keynes for the answer:

Keynes went on to explain that economic understanding required an amalgam of logic and intuition and a wide knowledge of facts, most of which are not precise: “a requirement overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision”. On this, as on much else, Keynes was right.

The moral of the story (to borrow a title from a famous book) is that you can have knowledge of lots of facts but they will be messy, imprecise, and very context dependent; or you can have knowledge of a few precisely-rendered facts that produce beautiful generalizations. What you cannot have is knowledge of lots of facts that produce beautiful generalizations.

In other words, beautiful generalizations will usually not fit the world well. (I said usually—I’m not making universal generalizations here). And intellectuals tend to strive for intellectual beauty.

What Kay leaves out is that lots of people thought they could get very rich by applying these economic models, and they of course had an incentive to ignore the facts that the models left out.

By the way, I have made a career out of arguing that moral theory is in exactly the same boat—broad generalizations captured by models or rules will leave out the messy details of moral reasoning that make it genuinely responsive to life’s complexity.

I guess the difference is that no one has figured out how to get rich off models of morality.

If you figure that out, let me know (and don’t tell anyone else).