Q: How important is it to understand what people are thinking and feeling when you are trying to understand the economy as a whole?
That's been a controversial question in economics for a long time. Milton Friedman wrote a collection of essays in 1953 called Essays in Positive Economics, in which he argued that you shouldn't try to infer what people are thinking because people really can't tell you what they're thinking. If you ask people why they did something, they will give you a conventional answer or mislead you. The idea was that the essence of economics is to look at the constraints that people have and assume that people are behaving rationally, subject to those constraints, and interpret economic data as reflecting that rational behavior. That is the defining characteristic of economics as a discipline — as opposed to psychology as a discipline — that, in understanding something as massive as the economy, it's best to look at people's actions, not their ostensible reasons. There is some appeal to that. I just wish it were more right.
I can get enthusiastic talking about this theory because, in some respects, it is good. To give an example, suppose you are trying to understand the seasonality of food prices — why they go up in the winter and down in the summer. Well, it's pretty obvious that it has something to do with the weather as a constraint, but you better think it through, because we live in a global economy, and when it's winter up here, it's summer down south. Obviously they'll ship food from one hemisphere to another. That puts a limit on seasonality. This is pure economics, and I'm sure it's right, because the seasons occur year after year after year, and you have people whose job is to ship fruits and vegetables and food around. They're going to find the best pattern of shipping, given all the costs. It wouldn't make a lot of sense to ignore that. Thinking that people get emotional in the summer, or something like that, would probably be wrong.
The problem is that positive economics has been carried too far. Part of the reason is an institutional specialization problem in academia. Academics have to specialize in some method of research; you can't know it all. This positive economics took over, and I think there's an institutional reason why it got overemphasized.
Fortunately, there's a lot of enthusiasm among some people for behavioral economics now. It's obvious that there are certain phenomena that don't fit into Friedman's prescription of positive economics, and those include speculative bubbles, for example. They're kind of hard to pin down, but they really are there.
Q: Some economists say that the positive approach gets you 99% of the way there and behavioral is about that last 1%.
I've heard that before.
Q: Where do you put the number?
I think that the failure to predict this financial crisis had something to do with failing to understand behavioral economics. So I don't think that it's 99% there. I think it's kind of the other way around. Positive economics is great for explaining the seasonality of fruit and vegetable prices, but if you want to know why we go through financial crises, I think you need behavioral economics.
Q: The disciplinary problem you describe in economics seems to have a very direct effect on economic activities outside of academia.
Right. This world now has over six billion people. We couldn't have sustained this number of people 100 or 200 years ago. In order to sustain them, we need modern, big business activities going, and the framework for that is the financial framework. We have to recognize that billions of lives depend on this. Finance, and economics more broadly, is a technology that has brought us to a very different world, and it's a necessary technology now.
Q: You mentioned speculative bubbles as an example where you might need a behavioral explanation. Can you explain your thinking behind that?
Q: You see confidence as a major part of animal spirits. We hear the word all the time, but is it well understood or measured now?
Q: You're saying that the logic of the story shapes people's expectations. The story of the internet entrepreneur becomes widespread and all of a sudden you have different expectations about what you should be doing next week or next year.
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