James Forsyth

The importance of behavioural economics

The importance of behavioural economics
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David Brooks is the finest American political commentator. But he dedicates one of his two columns a week to brain science. Brain science is, even to someone like me who gladly gave up science at 16, absolutely fascinating. It also has a real relevance to charting a way out of this current crisis.

Brooks’ column today is a look back at why the economy might not recover because of social factors. His focus is on the US, but his insights apply equally well to this country. Here’s the key section of it:

“During 2010, the economic decline abated, but the recovery did not arrive. There were a few false dawns, and stagnation. The problem was this: The policy makers knew how to pull economic levers, but they did not know how to use those levers to affect social psychology.

The crisis was labeled an economic crisis, but it was really a psychological crisis. It was caused by a mood of fear and uncertainty, which led consumers to not spend, bankers to not lend and entrepreneurs to not risk. No amount of federal spending could change this psychology because uncertainty about the future remained acute.

Essentially, Americans had migrated from one society to another — from a society of high trust to a society of low trust, from a society of optimism to a society of foreboding, from a society in which certain financial habits applied to a society in which they did not. In the new world, investors had no basis from which to calculate risk. Families slowly deleveraged. Bankers had no way to measure the future value of assets.

Cognitive scientists distinguish between normal risk-assessment decisions, which activate the reward-prediction regions of the brain, and decisions made amid extreme uncertainty, which generate activity in the amygdala. These are different mental processes using different strategies and producing different results. Americans were suddenly forced to cope with this second category, extreme uncertainty.

Economists and policy makers had no way to peer into this darkness. Their methods were largely based on the assumption that people are rational, predictable and pretty much the same. Their models work best in times of equilibrium. But in this moment of disequilibrium, behavior was nonlinear, unpredictable, emergent and stubbornly resistant to Keynesian rationalism.”Homo economicus is a flawed way of thinking. Man is not, and never has been, a purely rational economic actor. We need the insights of behavioural economics if we are going to chart a way back for the economy.

Written byJames Forsyth

James Forsyth is Political Editor of the Spectator. He is also a columnist in The Sun.

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