Economists have been derided for failing to foresee major shifts in the financial landscape and missing clues that pointed to a sudden stock market catastrophe. But now, in the early years of the third millennium, more fundamental questions have been raised about the foundations of the subject—these ones too difficult to dismiss.
First is the fact that its key doctrines, laid down first by John Maynard Keynes and then Milton Friedman, were tried to destruction in the 20th century, often with unhappy results.
Second is a more fundamental failing. Since the subject’s very earliest days, economics has more or less relied on the idea that humans act rationally: that they always act in their own self-interest, and that such actions, in a fully functioning market, will make society better off (see The invisible hand).
However, this does not explain why people frequently take decisions that are ostensibly not in their own interests. It is in no one’s self-interest to send themselves to an early grave, but despite widespread knowledge about the dangers of lung cancer and obesity, people still smoke and eat fatty foods. Similar arguments have been levied against climate change and man-made pollution.
New disciplines such as behavioral economics (see Behavioral economics) have revealed that much of the time people take decisions based not on what would be best for them but on so-called heuristics—rules of thumb from their own experience—or by copying others.
Conventional economics assumes that people can skillfully select the best product for their interests despite the complexity of the task. That this was a flawed assumption was proven as housing markets boomed in the early 2000s. Many less well-off families took out mortgages not realizing that, after a few years of cheap interest rates, their monthly repayments would suddenly shoot up to unaffordable levels. Conventional economists did not foresee the scale of the subsequent crash in part because they failed to appreciate that people were taking apparently irrational decisions which would ultimately cause them to lose their home.
A pick and mix approach In the light of the realization that people don’t always act rationally, regulators are likely to become more paternalistic in the future. There are, for example, already attempts to regulate the mortgage market more stringently so that it is less easy for consumers to make choices against their best long-term interest.
Economics is evolving from a subject that placed an almost limitless amount of faith in the ability of markets to determine outcomes to one that questions whether markets always come up with the preferred outcome. Rather like the modern novel, which picks and chooses from a variety of different styles instead of limiting itself to one discourse, 21st-century economics will pick and choose widely from Keynesianism, monetarism, rational market theory and behavioral economics to come up with a new fusion.
the condensed idea
Intervene when people are not rational
| timeline | |
|---|---|
| 1776 | The Wealth of Nations by Adam Smith is published |
| 1930s | Great Depression ushers in Keynesian policies |
| early 1980s | Monetarist ideas are implemented by Ronald Reagan and Margaret Thatcher |
| 1990s | Behavioral economics gains popularity |
| 2000s | A new fusion of economics starts to gain favor |