Blinded by sophistication

If your country is in the midst of a recession and the government gave you a $1000 tax cut, what would you do with it? Macro-economists use questions like this one to calculate a factor known as the consumption function, based on which they design national economic policy.

Back in the 1930s, John Maynard Keynes proposed that each family (depending on their income level) would spend a part of this $1000 and save the rest. Naturally, richer families are capable and more likely to save larger proportions of this windfall.

Another stellar economist, Milton Friedman, assumed that families would distribute the expenditure of this money across a few years, and tweaked the consumption function to accommodate this smoothening out using what he called the permanent income hypothesis.

Yet another economist, Franco Modigliani, deemed that people would not just plan a few years, but allocate the spending of this windfall over the rest of their life, while accounting for possible bequests! He called his theory the life-cycle hypothesis.

As if this wasn’t complicated enough, along came Robert Barro to push up the sophistication lever even further. He assumed that each person would care about bequests to their children and grandchildren, who would in turn think about their own progeny over an infinite time horizon.

When we have a bit of cash in our pockets, I wonder how many of us worry about our unborn great-great grandchildren. And yet, those progressively unrealistic, but more sophisticated models are used to determine our consumption.  They probably flow into economic policy in several nations.

Reading about this sparks surprise at first, and indignation later. At some point, macro-economists assumed that everybody in the world was as mathematically sophisticated as the smartest among them, and set off on a race to prove whoever was smarter. Whenever somebody pointed out to them that the average person wasn’t nearly as sophisticated, they assumed, with little empirical evidence, that people behave “as-if” this were true. They assert that people, though their gut instincts, have enough willpower to hold back from spending a $1000 windfall for successive generations, even as large sections of the same people routinely suck on cigarettes and drown themselves in alcohol every now and then.

The race to the top of the sophistication ladder among economics leaves reality firmly behind. The upcoming field of behavioral economics seeks to fix these problems caused by several decades of nearsightedness. But isn’t “behavioral economics” an absurd name for a field? We don’t have fields called “life biology”, “religious theology”,  or “human anthropology” because those terms are redundant. Behavioral economics would belong to that list too, if only economists hadn’t neglected human behaviour for several decades.

As the economics profession indicates, the human brain has a propensity towards sophistication while abandoning reality. In such instances, it pays to be an enfant terrible (Richard Thaler et. al.) who calls the emperors out for having no clothes.

Inspiration: Misbehaving – Richard Thaler

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