Psychology and the Economy

I’m currently sat in the RSA lunchtime lecture with Robert Shiller about how human psychology drives the economy.

John Maynard Keynes famously used the term ‘animal spirits’ to refer to the animating forces that drive people to action. He argued that economists were wrong to model human behaviour as rational, an emphasized that no-one can accurately predict human actions: it’s a question of gut feel. Writing as he was during the last great depression, the timing couldn’t be better to bring these ideas back into focus now.

One of my pet hates is the ‘efficient markets’ hypothesis that bases its argument on that great Enlightenment myth that human beings are rational. If you still believe that people make rational economic choices, go visit an ad agency for a day. In fact, John Nash whose game theory mathematics is the basis for much of the efficient markets theory, is on record as saying that the lesson of his life struggling with mental illness is that he was wrong, human beings aren’t rational. (Although, as the chair Daniel Finkelstein just argued, perhaps we are rational, it’s just that we’re all just trying to get laid.)

Shiller and his associates in ‘behavioural economics’ are unpicking this by investigating real human motivations. It’s a model for a new kind of economics based on a modern understanding of the human mind, and it’s long overdue. Shiller still maintains that he doesn’t understand how traditional economists think: “something about it just doesn’t sound right”!

Emotional feedback is the key argument: the fluctuations of the economy, notions of ‘fairness’ and corruption (something economists rarely mention) generate emotional responses (anger, mistrust, fear) which affect the economy. Confusion is a big factor too: even if people were rational, they need complete, comprehensible information to inform their choices.

Most interestingly, they follow some recent psychologists like Robert Sternberg in arguing that the human mind is structured around stories. Different stories emerge in good and bad times and amplify the economic effects.

This all makes sense to me. We are driven by far more than self-interest, and the way we perceive the world – our emotional reality – clearly has a massive impact our economic behaviours and the economy. It’s mystifying to me that so few economists are interested in what goes through people’s heads during economic crashes. Economics (much like my experiences of studying history actually) seems to operate on the basis that people are robots and we can and should ignore how we feel.

If Shiller and his colleagues are right, our collective mental health is critical to economic stability. That obviously means Mindapples is more important than I thought. But more than that, if we step back and look at the emotional stability of our economy, we are collectively volatile, panicky and scared. If our society was a person, it would be permanently on edge all of the time – like Woody Allen on speed.

So what can we do to make our economic system more emotionally resiliant? I just asked Shiller and he suggested that the bailouts of Northern Rock and the like were actually smart psychological moves to nip bad stories in the bud and ‘calm’ the markets. But how can we improve the system itself to be less jumpy? Do we need compulsory anti-anxiety meds for Wall Street?

One thing seems clear: by looking after our mental health we contribute to a healthier economy and a more stable society. If you want to heal the economy, heal thyself. And don’t panic: leave that to the economists.