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 It’s not that the main economic theories are wrong, but that they are incomplete. Trying to explain how markets work at a micro level without taking into account human behaviour is to ignore the fact that humans are the main economic actors. And trying to explain how the world economy works at a macro level without taking into account the political objectives of individual countries is to assume, some how, that all nations pursue the same ends. However, mathematically modelling human behaviour and national objectives is profoundly difficult, and so most economic theory simply ignores them and thus their explanations are simply wrong.

Let’s focus on human behaviour. The dominant schools of economic thought hold that humans will behaviour rationally and in their own self-interest and that when this happens en masse, the outcome works to the advantage of all. This appears true in many cases and it is the basis of the way many economies actually work – the most successful economic model, capitalism, is based on this principle. The trouble is that as soon as we factor in actual human behaviour, then the model is under strain – in capitalism, too much self-interested behaviour leads inevitably to cycles of boom and bust, to asset bubbles forming and then exploding, and to the type of greed-driven behaviour exemplified by the ‘rogue traders’ who have caused banks to lose billions of dollars, euros and pounds.  

But is it true to say that people behave in a way that is rational? There are certainly times when this might be true, especially at a subconscious level, but almost all human behaviours actually seem to be driven by two things: emotions and habits.

As I argued in a previous blog, the dominant emotion in economic terms appears to be ‘greed’, the desire to obtain more of a good than is either ‘needed’ or ‘desirable from a group perspective’. Greed distorts the ‘zero sum game’ model in which for every winner there is a loser (or, in economic terms, for everyone that has a good, there is someone who does not have it). A few individuals seek to dominate the market for a good so that there are a few who have the good and a lot that do not. Such behaviour is often driven by a desire to control the supply of a product (a good) so as to drive up its value due to scarcity – a behaviour that displays greed in its rawest sense and is entirely self-interested, and which benefits only the person involved and disadvantages society as a whole. It is greed that is behind the trading behaviours of many in the banking and finance sector although other emotions such as desire for recognition, craving for attention, and even fear of failure also play a part – and this greed is encouraged by the corporate cultures of the institutions involved because greedy traders make bigger profits (in the short term) and that benefits the institution and fulfils a basic reason for its existence. However, when allowed to occur in an unregulated way, it also creates a sense of being beyond risk with the inevitable collapse as a result.

Greed is also behind the asset bubbles that regularly and frequently occur in free-market economies. Take housing as an example: the true value of a house is, in capital terms, the cost of replacing it (purchase of land, materials and building work). There is also an intrinsic value, which is determined by supply (how many such houses are available) and demand (how many people are prepared to pay to own one). But why should anyone want to ‘own’ a house? Sure, as Maslow theorised, there is a need to have a place to live, to provide protection from the elements and other threats to survival, but that can be satisfied by renting, so why own? The normal answer is that the house is an asset and an investment but this suggests that the house owner is prepared to sell when the market price rises to a level that provides the return they want – but then they would have no where to live and, anyway, only a very small percentage of house owners would sell their house because pride (an emotion) of ownership and the fact that house ownership conveys recognition of status in some societies more or less forces them not to sell. By refusing to sell, the market becomes inelastic and reduces the supply side of the equation and if demand holds up, then the perceived intrinsic value of the house rises as people will be prepared to pay more to obtain one. Thus in an inflexible housing market in which demand is sustained, house owners think they are making money.

But, I would suggest, we need to look deeper at why anyone would want to ‘own’ a house. House ownership causes the population to become more static and less flexible in terms of movement to where jobs are – if a good job is available in a distant part of the country, then the family will have to move, the house has to be sold, a new house has to be obtained and although this is, in theory, very simple, in practise it can prove to be incredibly difficult to achieve. Partners don’t want to move: they like it here, the children are in good schools, fear of the unknown pushes them outside their comfort zone and a rational economic decision is impossible due to emotional reasons. The result is often disharmony in the relationship, a decision is made that is not in the self-interest of the individuals concerned, and everyone loses.

And then there is the culture of the society and the habits this engenders. In many societies, people are encouraged to own a house because house ownership is a cultural norm and it becomes habitual for people to abide by the norms of the culture even when such norms and habits are clearly (from an economic perspective) not in the self-interest of the individuals.  

The above example is just one of many that can be used to understand that emotions can get in the way of rational (economic) decision making and even the ‘bounded rationality’ I discussed in my previous post. The trouble is, emotions and their impact on human behaviour are not conducive to being mathematically modelled and so economists simply ignore them with the result that their vaunted economic models are bound to produce only approximations and are thus extremely unreliable foundations for political policy making. It is not the greed of bankers that produced the current global financial crisis but the habitual greed and self-centred self-interest of all those involved: potential owners, the society that pushes house ownership as desirable, politicians who fail to regulate correctly, bankers that see easy profits, and a culture that encourages the consumption of goods to excess.

And just in case you are wondering whether I am proposing abandoning a market economy for a socialist ideal, the answer is no, I am not! Market economies do appear to be the best solution to the development of the world but unregulated market economies are bound to a cycle of boom-and-bust and politicians should be wise and light in their regulation, but regulate they should to ensure the good of society. Unfortunately, such wise politicians are not to be found amongst those who seek political power – they, too, are driven by greed and self-interest and so the cycle continues.

In the next post, I will look at the impact of habits on economic decision-making and how observing the change in habitual behaviour can smooth out the ups and downs of economic life.

Alasdair White has been a business school professor and management development consultant  for over 20 years. He has written five best-selling management books and a thriller. He is currently writing a second thriller.