Arnold Kling  

The Macro Doubtbook, Installment 10

Moral Relativism and Modern Ti... Not Robin Hanson or Tyler Cowe...

The previous installment was here. The installment below covers behavioral economics.

Recall that the ultimate approach in the Doubtbook will be to stitch together the history of macroeconomic thought with the history of macroeconomic episodes. The opening chapter looks at all of the different sub-fields of economics that macroeconomists turn to for their theories. We are still in the opening chapter.

Behavioral Economics

In frictionless markets with optimizing behavior on the part of individuals, one would not expect to see unemployment. I think of behavioral economics as studying deviations from optimizing behavior. Non-optimizing behavior could itself account for macroeconomic phenomena. In addition, non-optimizing behavior may help to explain market frictions.

For example, Animal Spirits, by George Akerlof and Robert Shiller, places heavy emphasis on behavioral economics as the source of economic fluctuations. They claim the mantle of behavioral economics for Keynes, or vice-versa.

One of the puzzles of macroeconomics is the fact that downturns produce an excess supply of labor, rather than a reduction in wages. Many explanations for this rest on psychology. For example, there is the "efficiency-wage" theory, which says that the quality of work effort is positively related to wages. Firms are reluctant to cut wages in a recession because they believe this will reduce effort.

Akerlof and Shiller offer the theory that workers care about fairness. Workers may perceive a cut in wages as unfair, and they will resist such an approach.

Even though one firm may resist wage cuts, in a dynamic market wages might go down, anyway. For example, suppose that there are two firms in the same industry, one of which uses low-skilled workers at low wages and the other of which uses high-skilled workers at high wages. Even if each firm's wages are fixed, in a recession some high-skilled workers might shift to lower-wage jobs, reducing the average wage. However, they would not make this shift if they perceive that lower wages are unfair, given their skill level.

Another idea is that if firms cut wages, they leave the choice of who leaves the firm up to the worker, and the firm may lose its best employees. Instead, using layoffs gives the choice to management, so that the best employees can be retained. However, this raises the question of why a firm would lay off its least valuable employees, rather than selectively cutting their wages. Again, one may wish to appeal to the behavioral economics notion that workers would see selective wage cuts as unfair, and this would hurt morale. If you selectively fire workers, their morale is damaged, but they are gone. If you selectively cut wages, the workers whose morale is hurt are still around, perhaps reducing everyone's productivity.

However, again consider a dynamic economy with many firms. If some firms lay off workers, then in theory new firms can enter, offer low wages, scoop up cheap labor, and earn high profits. Explaing why this does not occur might require really stretching the behavioral economics story.

Akerlof and Shiller also invoke behavioral economics to explain booms and busts. Individual expectations for returns on assets are naively based on recent past returns. That creates strong momentum in asset prices, leading to bubbles and panics.

Keynes himself offered a more subtle view of animal spirits. He suggested that the future is not knowable, and entrepreneurs must decide how to proceed even though they lack vital information. When their mood is optimistic and aggressive, they invest heavily. When their mood is pessimistic and defensive, they scale back their investment. Again, one wonders about how this works in a dynamic market. If some firms are cutting back investment in a recession, then the low cost of capital creates opportunities for other firms to undertake profitable investment. Why does this not occur? Keynes would say that it is because pessimistic expectations about the future override the low cost of capital.

If some individuals behave irrationally, then what we have seen is that other individuals tend to have profit opportunities. If profit opportunities go unexploited, then I would argue that there must be some market friction. Therefore, my view is that we need more than just behavioral economics to explain macroeconomic phenomena. We will need to understand market frictions, whether or not we also include systematic non-optimizing behavior in the story.

Comments and Sharing

COMMENTS (5 to date)
Lord writes:

The problem is beliefs can become self fulfilling. If most believe it is a bad time to invest, it will become a bad time to invest regardless of other fundamentals. Beliefs are self limiting though and it is impossible for expectations to not catch up with and exceed reality which will reverse expectations countering what they have set in motion.

No, a lack of frictions would not result in equilibrium, but violent swings due to psychology.

fundamentalist writes:

Agreed. Behavioral econ explains some aspects of the business cycle, but not the cause.

eccdogg writes:

Thought I generally disagree with him, I tend to agree with Keynes in this area.

I think a variable that has huge impact on economies is the market price of risk. This can be infered from P/E ratios, junk bond and corporate yeild spreads, the steepness of the yield curve, implied volatilities etc.

There is no fundamental reason why x units of risk (broadly defined) should be compensated for by y units of return. Sure there are historical norms and ranges, but these are not fundamental laws but instead based on the preference of people who act in the market.

There does not seem to me to be any reason that those preferences cannot change for large groups of people at the same time and thus drive up or down the market price of risk. This makes people flee to safety and thus retreat from investment and leveraged spending.

There is no reason that a dynamic economy would balance this out. If the marginal risk taker got less aggressive then the next guy in line by definition needs a higher return to justify the activity and thus spreads must go up.

Todd Martin writes:

Checked in for any comments on Stockman NYT Op-Ed but read this instead. (Please do comment on DS Apocalypses).

Like you a Swarthmore Econ guy, and having lived this world for 30 years in business, humbly offer a few thoughts:

Sometimes you can't reduce wages -- union contracts, morale for majority. By far most typical is you need less people (in recession) and you lay off your weakest performers. Then you delay hiring again as long as practical & considering (subjective) risk/reward outlook.

Entrepreneurs "moods" are influenced by many factors; constant intuitive absorption/assessment of all external and internal factors -- essentially rational but complex, with an element of "gut" judgment.

Re your Behavioral vs Dynamic questions, some entrepreneurs may see an opportunity while others are scaling back, but they are often unable to get financing. Merely arbitraging labor/skill availability is insufficient; you need an investable business proposition and financing.

Pietro Poggi-Corradini writes:

I agree that at the aggregate level market dynamics needs to be better understood, but going back to wage stickiness, my understanding was that workers accepting wages comprises an unwritten contract whereby the employer assumes the risks of monthly fluctuations, i.e. wages are a form of insurance which is "paid" by workers by forgoing the high gains in good times. If that's the case, it's not hard to see why one would object to lower wages: it entails writing a new contract.

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