Jackson Hole Economics’ mission is commendable. JHE strives to understand why things “went awry” and how to develop “sustainable” solutions. In fact, their aims are related to the underlying theory used to analyse and justify economic decisions.
If something is not sustainable it may, in the extreme, cease completely. It nearly happened to the financial system in 2008, leading to the Global Financial Crisis (GFC). Supposedly it was a once-in-a-lifetime event. Yet today we face the ‘Coronavirus Crisis’ (CvC), an even bigger economic disaster.
Importantly, the coronavirus did not cause the weakness of the economy—it merely exposed it. The underlying vulnerability is physics envy. It is a mental virus, which infected economics decades ago.
I prefer to call it mechanical economics: it views the economy as a machine, the market as an automaton, and humans as robots. Nobel prize laureate Robert Lucas put it this way:
[Economics is] something that can be put on a computer and run. This is what I mean by the ‘mechanics’ of economic development – the construction of a mechanistic, artificial world, populated by the interacting robots that economics typically studies . . .
Implied in this worldview is the assumption that such mechanical entities can be “fixed” by calibrating, optimising, and tweaking via models and tools. Pulling a lever here, pushing a button there, and turning the switch in the middle is all that is required. That thinking is popular among policy makers who think they can steer the economy.
For example, former Fed Chair Janet Yellen believes monetary policy is like driving a car: “Right now our foot is still pressing on the gas pedal. Our foot remains on the pedal so that we can make sure economic expansion remains strong enough to withstand an unexpected shock.”
Mechanical economics is characterised by overreliance on mathematical (and increasingly AI) models, overconfidence in engineering, and a tendency for manipulation.
This is dangerous because it ignores the fact that humans have conscious minds which extend into real and financial markets. We adapt and act spontaneously. Specifically, cognitive science tells us that there is nothing mechanical about consciousness. That is crucial for economic discovery. The reflexive chain of discovery, for instance price discovery, sustains the economic system for the benefit of society. Such discovery relies on conscious minds.
Lehman’s collapse in 2008 offered a momentous but painful lesson. Unfortunately, not everybody got it. Famously, Queen Elizabeth pointedly asked mainstream economists “why did nobody see it coming?” Clearly, economists didn’t get it, as reflected by the lack of self-criticism in their subsequent reply to Her Majesty.
What about this blind spot? The GFC exhibited a tail-wagging-the-dog dynamic in which market mentality impacted the real economy. Nobel laureates George Akerlof and Robert Shiller subsequently recognised that “[w]e will never really understand important economic events unless we confront the fact that their causes are largely mental in nature“. A similar acknowledgement comes from Fed Chair Jerome Powell who admitted that “[t]he linkages among monetary policy, asset prices, and the mood of global financial markets are not fully understood”. It followed George Soros’ warning a decade earlier that “markets are not supposed to have moods. Yet they do.”
Martin Wolf consequently argues that economics “needs rebuilding” because it does “not fully understand the economic dynamics”. Larry Summers echoed that “[s]omething is wrong with the economics profession if events like those of 2008 do not change its thinking”. Andy Haldane adds, “[i]f a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will.”
Despite these pleas, mechanical economics continues to rule the roost, in theory and practice. Consequently, imbalances worsen, including between the market and economy. It is reflected in debt levels and inequality, but also market concentration and overvaluation.
Economics clearly needs help. The acknowledgements by Akerlof & Co are correct: mind-matter issues are indeed at the centre of markets. However, they are not native to economics. This is where cognitive science can contribute. It will finish what behavioural economics started. Allow me to highlight a few of its recommendations to improve economics:
- Focus on the internality of mental life, not just the external behaviour. Replace the “black box” of “the robot” with the internal economy of a conscious being, able to adapt and change behaviours as circumstances evolve.
- Embrace metaphysics and explore consciousness, mentality’s final frontier. As neuroscientists Koch and Tononi argue, “the study of consciousness is becoming a science”.
- View the mind beyond the brain. It is embodied (e.g., gut feelings), extends via technology (e.g., your ‘smartphone’) and bridges to other minds creating social decision-making units, for example the market mind.
Economics is the study of choice amid scarcity. It reveals powerful insights into how individuals act and how their actions impact others. But like all (social) sciences, it must evolve as research unveils more about what drives human thinking, behaviour and decision-making. Just as behavioural science challenged the foundations of choice theory underlying classical economics, so too can cognitive science contribute to enhance our understanding of how individuals and groups arrive at decisions.
Neuroscience—which is part of cognitive science—offers fascinating new insights in that regard. For example, as part of the answer to Powell, mood affects decision making via beliefs. Moreover, via brain scans we can probe the neural activity of traders and relate it to their decisions. One study on “trader intuition” found how skill in forecasting price changes in markets with insiders showed more activity in the dorsomedial pre-frontal cortex and correlates with the general ability to detect intentionality in one’s environment. In other words, those who made the most money could read the market mind best.
“[E]conomists can never be free from difficulties unless they will distinguish between a theory and the application of a theory”. Those words by William Stanley Jevons in 1871 have not been heeded. The GFC and CvC are reality checks that expose flaws in our thinking, but which remain largely ignored. Considering the economy as machine, the market as automaton, and humans as robots is an ontological mistake, and a very expensive one at that.