Emotions are getting in the way of economic theory.
There was much laughter over the economist who presented a paper that assumed people made optimal calculations when deciding on higher education. The paper plodded on for pages, but came to a grinding halt with a mathematical equation that the presenter could not solve - without the wit to conclude that the study demonstrated that one needed a degree in mathematics in order to decide whether to go to university.
Can people make sophisticated, rational calculations when they are making highly complicated decisions on education, career path, location and housing, having children and even partners? They simply don't have the mathematical power, and usually don't have all the necessary information, either. Yet economists have pursued this rationality assumption with an obsessive vigour. Even if in their own life they use non-optimal decision rules and rely on intuition - as with the rest of us. (Sometimes reading a mathematically abstruse economic paper purporting to describe human behaviour, one thinks, "The writer has never fallen in love.")
I suppose the rational calculating optimiser interested only in himself (the economist's model of man is very masculine) was a reasonable hypothesis when there was no empirical evidence of how people behave. But psychologists have been collecting evidence that suggests the hypothesis can be misleading. So much so that one of the recipients of the Swedish Banks' 2002 economics prize in honour of Alfred Nobel was a psychologist, Daniel Kahenman. (His co-researcher Amos Tversky would have been similarly honoured had he not died in 1996.) The two found that people making decisions in uncertain times often depart from what is expected under standard economic theory because they rely on shortcuts when analysing complex circumstances. (So we chose to go to university without a degree in mathematics to help us decide.)
There is now a band of economists who are exploiting the psychologists' insights. The 2004 J B Clark medal, the second most prestigious prize in economics, was awarded to economist Matthew Rabin. (He is quite a character - very sweet, modest, loud clothes, zany sense of humour - who makes economists seem fun. We can't have that!) Steeped in the psychological literature, Rabin and others use mathematical models based on psychology to draw extraordinary economic insights. Once economists invaded other disciplines' territories with imperial arrogance. But the successes have been those who have co-operated with the other disciplines.
Does it matter? An official told journalist Bob Edlin that Treasury was "trying to get to grips with the importance of this work and how it can be translated into policy". Yeah, right. Apparently, they think "that the lesson may be that governments would do well to give up trying to finetune the economy", which was exactly their policy under the old theory. Have they learnt nothing? I would have thought that the evidence of individuals using rules rather than optimising behaviour, such as explicated by Richard Thaler (on my website), suggests that our policy strategy towards private savings and an individual's educational investment is fundamentally misconceived. Sadly, there remain "rationalist" economists who are reluctant to abandon their narrow rationalist training for the richer insights that are becoming available (which itself is an irrational thing to do).
It is not just big questions where economic calculus does not seem to work. Consider the choice between $3000 now and $3800 in a couple of months. Hardline economics says that it depends on your "time discount rate". It also depends on whether you have been sucking sweets. Those who have forgo the instant gratification of cash now for more in the future. The hardliners treat the discount as a fundamental variable. Rather, it appears to be at the whim of one's blood sugar level. (Of course, most mothers know the sweeties trick, but watch out for your banker offering you a lolly - perhaps they should.)
Another disturbing - or, if you wish, humanising - finding involves the "ultimatum game". I described the rules in a December 2000 column (also on my website), but here we need only observe that most people ignore the obvious rational economic strategy, and give their opponent more than self-interest requires. Physiological studies show that people who do so have elevated levels of oxytocin, the hormone associated with birthing, breastfeeding, touching, making love and - more generally - human bonding. Emotions matter in economic decisions.
So it is not just that we don't do the complicated mathematical calculations that the rationalist economists assume (even if they can't always do them themselves) and instead use rules of thumb, which give different results to the optimising mathematics. We also take into account others' interests. As John Donne says, no man is an island, entire of itself, but is a part of the continent of all humanity. The bells that toll for Christmas and New Year also toll for thee.