Why Bubbles Burst, Why Creativity Withers

By Shlomo Maital


  In the latest edition of BBC’s Global Business, Peter Day chats with UK economist Paul Ormerod, who knows what’s wrong with economics and why it has failed.  If you don’t want to read this long blog account of their conversation – here is the essence.   

     In 2003 Nobel Laureate Robert Lucas (he won it in 1995) said this:  “Macroeconomics … has succeeded. Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”   Really?  Is the global Depression that started with the Lehman Bros. bankruptcy in 2008, and is still ongoing,  chopped liver?   If it is solved, Nobelist Lucas, why did former European Central Bank Governor   Jean Claude Trichet say, “at the time of crisis policy-makers felt abandoned by economic theory, which was of no use whatever”.  Why did Ben Bernanke recently say that economic theory is wonderfully good only at explaining why we made mistakes in the past….  Why would an intelligent human being EVER say any complex social problem was solved forever?  So what is wrong with economics?  Ormerod, in his new book  Positive Linking: How Networks and Incentives can Revolutionize the World, explains it simply. Economics ignores other people. Decisions are made by one rational, highly rational, person.  In reality, we copy others.  We do what they do.  That means that there are persistent bubbles, because people do what other people do, as all of us belong to networks, groups of persons who influence one another.  That’s why so many people destroyed themselves and their companies by investing in credit default swaps and mortgage-backed securities.  Everybody else was doing it.  So the lesson here is, while you are copying others, THINK INDEPENDENTLY.   And if you want to remain creative, reserve part of your brain for creating NEW CHOICES, rather than just blindly going with existing ones everyone favors.    

 This is an account of the conversation between Peter Day and Paul Ormerod:

   “ What on earth  is wrong with economics?   Storm clouds, the boom comes to an end, economies fall, companies fail, banks go bust, and despair, uncertainty and turmoil affect ordinary people caught up in a Depression.  It happened in 2008; the effects are still with us.  Were the people in power steering by the wrong stars?   Paul Ormerod’s  first book, 20 years ago,  was  The Death of Economics; next he wrote Why most Things Fail.  Recently : Positive Linking: How Networks and Incentives can Revolutionize the World.   (“Network” here refers not just to the Internet, but to all forms of social communities – any grouping of humans who influence each other’s behavior). Ormerod says:   “There are serious limitations in the way conventional economics is taught and written about.  Most serious:  It treats people as if they were operating in complete isolation from each other.  You make choices solely based on your own views, as if you were Robinson Crusoe.  With the development of the Internet, it is a poor description of the world.    Macroeconomics models weren’t just academic, they had traction among Central Bankers, based on the idea of a single individual. When the financial crisis came, it was a NETWORK problem; the financial viability of one bank impacted on others,  we worried about the cascade effect.  Economists’ models omitted from the models this network effect.    Big companies have rebuilt their balance sheets. They’re sitting on cash. Nobody wants to be the first one to move. As soon as one starts spending, others will follow– we’ll get an investment boom. But when???“

    “When we think of any market where there is popularity, e.g. fashion, books  (e.g. 50 Shades of Grey –not a great book, but it became popular because it WAS popular…),    Crowd effects.  We are like sheep. Investment markets behave like this.    The book The Madness of Crowds was written 172 years ago! (Charles Mackay, 1841!).  Keynes called it ‘animal spirits’.   This governs how the economy performs. It is the job of policymakers to intervene, to counteract animal spirits when they go bad.  How do you make people more optimistic?   The analysis here is psychological.” 

     “Herbert Simon, Nobel Laureate in Economics, was at his peak in the 1950’s.  The essence:   He observed how firms really took decisions.  He developed an alternative theory – he is the founder of the behavioral economics school.  In 1955 his article built the foundation for it.  In general, firms do not behave as economists say, rationality. The world is too complex.  They use some reasonable rules and use them until they fail.      Jean Claude Trichet, former ECB governor, said, “at the time of crisis policy-makers felt abandoned by economic theory, which was of no use whatever”. 

      “Rational copying person:  should replace the rational economic agent.  Copying is the way the network effect works.  The number of choices available today are phenomenal. McKinsey (consulting firm) says: on any single day, in NYC a consumer faces 10 billion potential choices!   That cannot be done in an economically rational way. You cannot gather information on all these 10 b. choices.  So you do what Herbert Simon said, you form short-cuts, heuristics, simple rules.  If you choose a restaurant, you ask your friends.  Copy what they do.  It’s a short-cut to deal with the world’s complexity.  Get a group of people whose opinion you trust, and you copy them.   There is a lot of this on the internet.  It is visible now:  “those who like this, bought that…”      This is left out of conventional macroeconomics.  In the macro model, one person makes decisions, a representative agent.  He/she represents the entire economy. They have to take rational decisions. 

  “In the U.S. choice is regarded as a badge of freedom.   A part of democracy.  But this bewilders people.  Choice has now exploded, grown exponentially.  In the 1950s, Simon discussed this – there are so many alternatives, how can I decide?  Even looking back, in most situations I can never know if I have made the best decision. All I can do is to hope to make a reasonable decision. The way to do that is to copy people’s behaviors whom I respect.  

     “Mid-price laptops in the German market:  There are 3,500 possibilities. How can you possibly choose?  How do you choose a smartphone?  Ask a couple of young people, what’s yours, and …I’ll have that.  More sensible than trying to evaluate 3,500 possibilities.   When people copy, when their behavior is driven by networks and social effects, we get cascades, bubbles…and sometimes collapse.”