Very few economists foresaw the great recession of 2008–2009. Why not? Economists have long assumed that human beings are “rational,” but behavioral findings about human fallibility have put a lot of pressure on that assumption. People tend to be overconfident; they display unrealistic optimism; they often deal poorly with risks; they neglect the long term (“present bias”); and they dislike losses a lot more than they like equivalent gains (“loss aversion”). And until recent years, most economists have not had much to say about the problem of inequality, which seems to be getting worse.
There is a strong argument that within the economics profession, these problems are closely linked, and that they have had unfortunate effects on public policy. Most economists celebrate free markets, invoking the appealing idea of consumer sovereignty. If people are buying potato chips, candy, and beer, or making risky investments, that’s their business; they know their own values and tastes. Outsiders, and especially those who work for the government, have no right to intervene. To be sure, things are different if someone is inflicting harms on third parties. If a company is emitting air pollution, the government can legitimately respond. But otherwise, many economists tend to believe that people should fend for themselves.
It is true that companies might try to take advantage of consumers and investors, perhaps with outright lies, perhaps with subtler forms of deception, perhaps by manipulating their emotions. But from the standpoint of standard economic thinking, that’s nothing to panic about. The first line of defense is competition itself—and the market’s invisible hand. Companies that lie, deceive, and manipulate people are not going to last long. The second line of defense is the law. If a company is really engaging in fraud or deception, government regulators might well get involved, and customers are likely to have a right to compensation. But for economists, competitive markets are generally trustworthy, and so the old Latin phrase retains its relevance: caveat emptor.
By emphasizing human fallibility, the group of scholars known as behavioral economists has raised a lot of doubts about this view. Their catalog of errors on the part of consumers and investors can be taken to identify a series of “behavioral market failures,” each of them calling for some kind of government response (such as information campaigns to promote healthy eating or graphic warnings to discourage smoking). But George Akerlof and Robert Shiller want to go far beyond behavioral economics, at least in its current form. They offer a much more general, and quite damning, account of why free markets and competition cause serious problems.
Both Akerlof and Shiller have won the Nobel Prize; they rank among the most important economists of the last half-century. They are also intellectual renegades. Akerlof has been interested in the persistence of caste systems, involuntary unemployment, rat races, the effects of personal identity, and what happens when sellers know things that buyers don’t. He has long been a proponent of integrating psychology and economics. A specialist in the financial system, Shiller has explored the role of “irrational exuberance” in producing wildly inflated stock, bond, and real estate prices, which are bound to come down. He believes that investors make serious mistakes, and also that they run in herds, which can produce bubbles. Like Akerlof, he is keenly interested in seeing what psychology can add to economic theory.
Akerlof and Shiller believe that once we understand human psychology, we will be a lot less enthusiastic about free markets and a lot more worried about the harmful effects of competition. In their view, companies exploit human weaknesses not necessarily because they are malicious or venal, but because the market makes them do it. Those who fail to exploit people will lose out to those who do. In making that argument, Akerlof and Shiller object that the existing work of behavioral economists and psychologists offers a mere list of human errors, when what is required is a broader account of how and why markets produce systemic harm.
Akerlof and Shiller use the word “phish” to mean a form of angling, by which phishermen (such as banks, drug companies, real estate agents, and cigarette companies) get phools (such as investors, sick people, homeowners, and smokers) to do something that is in the phisherman’s interest, but not in the phools’. There are two kinds of phools: informational and psychological. Informational phools are victimized by factual claims that are intentionally designed to deceive them (“it’s an old house, sure, but it just needs a few easy repairs”). More interesting are psychological phools, led astray either by their emotions (“this investment could make me rich within three months!”) or by cognitive biases (“real estate prices have gone up for the last twenty years, so they’re bound to go up for the next twenty as well”).
Akerlof and Shiller are aware that skeptics will find their depiction of human beings as “phools” to be inaccurate and impossibly condescending. Their response is that people are making a lot of bad decisions, producing outcomes that no one could possibly want. In their view, phishing for phools “is the leading cause of the financial crises that lead to the deepest recessions.” A lot of people run serious health risks from overeating, tobacco, and alcohol, leading to hundreds of thousands of premature deaths annually in the United States alone. Akerlof and Shiller think that it is preposterous to believe that these deaths are a product of rational decisions. Many people face debilitating financial insecurity, largely as a result of their own mistaken decisions, spurred by phishermen. Bad government is itself a product of phishing and phoolishness, for “we are prone to vote for the person who makes us the most comfortable,” even when that person’s decisions are effectively bought by special interests.
In a reversal of Adam Smith, Akerlof and Shiller contend that the invisible hand of the market guarantees phishing. Consider Cinnabon, whose brilliant motto is “Life Needs Frosting,” and which attracts customers with a seductive smell (and which has not made caloric information on its products at all easy to find). Or consider health clubs, a $22 billion industry with over 50 million customers, many of whom choose expensive monthly contracts, even though they would save a lot of money if they paid by the visit. In effect, they are paying not to go to the gym.
Adapted from http://www.nybooks.com/articles/2015/10/22/why-free-markets-make-fools-us/