The Frontal Cortex

Paul Krugman's analysis of Milton Friedman's intellectual legacy is one of the best articles I've read recently. Krugman not only paints a balanced portrait of Friedman's accomplishments - great economist, bad popularizer - but ably summarizes the rival tensions in 20th century economics. It's all fascinating stuff, but I was particularly interested in this section on the rational agent model:

For most of the past two centuries, economic thinking has been dominated by the concept of Homo economicus. The hypothetical Economic Man knows what he wants; his preferences can be expressed mathematically in terms of a "utility function." And his choices are driven by rational calculations about how to maximize that function: whether consumers are deciding between corn flakes or shredded wheat, or investors are deciding between stocks and bonds, those decisions are assumed to be based on comparisons of the "marginal utility," or the added benefit the buyer would get from acquiring a small amount of the alternatives available.

It's easy to make fun of this story. Nobody, not even Nobel-winning economists, really makes decisions that way. But most economists--myself included--nonetheless find Economic Man useful, with the understanding that he's an idealized representation of what we really think is going on. People do have preferences, even if those preferences can't really be expressed by a precise utility function; they usually make sensible decisions, even if they don't literally maximize utility. You might ask, why not represent people the way they really are? The answer is that abstraction, strategic simplification, is the only way we can impose some intellectual order on the complexity of economic life. And the assumption of rational behavior has been a particularly fruitful simplification.

The question, however, is how far to push it. Keynes didn't make an all-out assault on Economic Man, but he often resorted to plausible psychological theorizing rather than careful analysis of what a rational decision-maker would do. Business decisions were driven by "animal spirits," consumer decisions by a psychological tendency to spend some but not all of any increase in income, wage settlements by a sense of fairness, and so on.

But was it really a good idea to diminish the role of Economic Man that much? No, said Friedman, who argued in his 1953 essay "The Methodology of Positive Economics" that economic theories should be judged not by their psychological realism but by their ability to predict behavior. And Friedman's two greatest triumphs as an economic theorist came from applying the hypothesis of rational behavior to questions other economists had thought beyond its reach.

It doesn't take a degree in neuroscience to realize that the rational agent model is deeply flawed. From the perspective of the brain, Keynes' arm-chair psychologism was far more accurate than Friedman's idealized assumptions. But even more damaging to economic science was Friedman's attitude that the validity of the economic assumptions was largely irrelevant. As long as economists could make reasonably accurate predictions about economic phenomena - like the rate of unemployment, or the value of the dollar - then our bewildering behavior in the real world was largely irrelevant. (Friedman often used Quine to justify his position.)

But now this naivete is beginning to crumble. There are two reasons. The first reason is neuroeconomics, which has its roots in behavioral economics, which is similarly rooted in prospect theory. David Laibson, an economist at Harvard, ably summarized the philosophy underlying neuroeconomics: "Natural science has moved ahead by studying progressively smaller units. Physicists started out studying the stars, then they looked at objects, molecules, atoms, subatomic particles, and so on. My sense is that economics is going to follow the same path. Forty years ago, it was mainly about large-scale phenomena, like inflation and unemployment. I think the time has now come to go beyond the individual and look at the inputs to individual decision-making. That is what we do in neuroeconomics."

The second reason economics is beginning to probe the limitations of the rational-agent model come from attempts to explain empirical phenomena that neo-classical macroeconomics can't explain. I won't go into the details here, but for those interested George Akerlof gave a terrific Presidential Address to the American Economic Association this year. His basic theme was that Keynes' armchair psychology was often more accurate in explaining consumer behavior than the intricate, mathematical models favored by neo-classical economists. It's time for economists to rediscover the mind:

This lecture has shown that the early Keynesians got a great deal of the working of the economic system right in ways that are denied by the five neutralities. As quoted from Keynes earlier, they based their models on "our knowledge of human nature and from the detailed facts of experience." They used their intuitions regarding the norms of how consumers, investors, and wage and price setters thought they should behave. There is systematic reason why such knowledge and experience is likely to be accurate: by their nature norms are generated and known by a whole community. They are known to those who abide by them, and those who observe them as well.