Wednesday, July 22, 2009

Evolutionary Biology Tries To Offer Economic Answers

This article was quite a fascinating read. It's always amusing to me how much the theory of evolution purports to be the be-all, end-all answer to human behavior, whether regarding sexual selection or, in this case, economic theory.

The push for financial regulatory reform has highlighted an important debate surrounding the Efficient Markets Hypothesis (EMH), the idea that market prices are rationally determined and fully reflect all available information. If true, the EMH implies that regulation is largely unnecessary because markets allocate resources and risks efficiently via the "Invisible Hand".
However, critics of the EMH argue that human behaviour is hardly rational, but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehaviour.

Initially confined to academia, the battle between EMH disciples and behaviouralists has spilled over to central bankers, regulators, and politicians, and the new regulatory landscape may depend on the outcome of this conflict. The strong convictions fuelling this debate have created a false dichotomy between the two schools of thought - in fact, both perspectives contain elements of truth, but neither is a complete picture of economic reality. Markets do function quite efficiently most of the time, aggregating vast amounts of disparate information into a single number - the price - on the basis of which millions of decisions are made. This feature of capitalism is an example of Surowiecki's "wisdom of crowds". But every so often, markets can break down, and the wisdom of crowds can become the "madness of mobs".

Why do markets break down? Animal spirits! Recent neuroscientific research has shown that what we consider to be "rational" behaviour is the outcome of a delicate balance among several distinct brain functions, including emotion, logical deliberation, and memory. If that balance is upset - say, by the strong stimulus of a life-threatening event - then reason may be cast aside in favour of more instinctive behaviours like herding or the fight-or-flight response.

Although few of us encounter such threats on a daily basis, much of our instincts are still adapted to the plains of the African savannah 50,000 years ago.
Personally, I don't agree with the efficient markets hypothesis (EMH), even though it does have some elements in common with classical Austrian economic thought. Though EMH may suggest that human behavioral is primarily rational, classical economics and the functioning of the "Invisible Hand" is not dependent on the rationality of buyers and sellers. Though the market may experience various oddities such as price distortion, overly-optimistic market speculation and dramatic temporal spikes in supply and demand, the Austrian position is simply that the invisible hand will naturally correct for these phenomenon and restore the market to a balanced state. For example, when an easy credit market creates a surge in short-term demand for real estate, resulting in the housing bubble that we have recently witnessed, the invisible hand simply ensures that prices will return to their real levels eventually. In this case, since housing prices were artificially high, market correction is occurring as the prices nosedive. Soon, the prices will rise slightly, returning to approximate real housing values. The invisible hand doesn't depend on people behaving rationally. In fact, I would quite agree that many people made poor choices in taking out loans to buy houses they really couldn't afford. This irrational behavior caused an artificially high level of housing demand. But unless people continue to act irrationally for long periods of time, the invisible hand will always restore equilibrium. And a family can hardly continue to act irrationally when they've been evicted for failing to make mortgage payments. The invisible hand itself forces people, whose excessive spending swiftly brings them face to face with economic reality, to return to reasonably rational spending. They can't afford not to!

However flawed the efficient markets hypothesis may be, I think the evolutionary position is utterly ridiculous. I love it! Rather than explaining what thoughts or emotions led people to make the economic decisions they did, behavioral economists claim that the whole problem is animal spirits! Animal spirits! Animal spirits are the reason that we are in the midst of an economic depression. What in the world does this mean? Thankfully, the article explains. The problem is that even though humans have evolved and learned to thrive in our modern environment, for some odd reason we still have instincts that are 50,000 years old. Apparently, all irrational human behavior is just because our behavior hasn't had enough time to adapt to a modern context. Naturally, if we just had a few million more years we might figure out how to buy things in a rational manner!

As an Austrian economist, my position is that a laissez-faire approach to economic will typically have the best results. Most regulation only serves to artificially limit the market and will always cause distortion or even market failure. I'm not at all worried about human economic "misbehavior" as they call it, since in a market where fair-play is ensured, irresponsible financial decisions only harm those who make them. If a family buys a house they can't afford, then only two parties are harmed: the family who has chosen to spend beyond their means, and the bank who took a risk by making an unwise loan. The only regulation we need is regulation that ensures fair competition. People will learn the rest through trial and error, since even people who behave irrationally often learn from their own mistakes.

But of course, if we really are nothing more than car-driving, newspaper reading, web-surfing gorillas, whose instincts are 50,000 years outdated, making choices on the basis of mystical animals spirits from the African savannah, then my theory could be wrong.

1 comment:

  1. now lets be correct here, we're descendants of a common ancestor of monkeys, not gorillas. Animal spirits? Are they kidding, do they actually expect anyone to believe that junk?