Posts Tagged ‘failure of economics’
Author Alasdair White
In this essay, Alasdair White takes a cold hard look at the current state of consumerism as an economic model and with the help of Daniel Kahneman and Nassim Nicholas Taleb concludes that consumerism and classical microeconomic theory is no long sustainable – it’s time for a re-think!
Are consumerism and the consumer society dead? Well, we’re all consumers but we don’t all live in a consumer society. This begs the questions as to what are consumers and what is a consumer society.
Consumers are those people who acquire, usually by buying, goods and services and then use them before disposing of them, often before the end of their useful life. This has given rise to the idea of a consumer society, which is one in which people often buy new goods, especially goods they want but do not need, and place a high value on owning many things. This, in many ways, is another way of describing economic materialism which is the excessive desire to acquire and consume material goods. It is usually closely connected to a value system that regards social status as being determined by affluence as well as the perception that happiness can be increased through buying, spending and accumulating material wealth.
In purely economic terms, this is directly contrary to the rational self-interest of the individual as an economic actor, a self-interest that is rationally served by the optimisation of the person’s scare economic resources – or, in other words, is best served by getting the best value for the limited money they have available. Very few people have an unlimited source of funds – almost all of us have income which is taxed leaving us with a disposable income from which we have to purchase the goods and services we ‘need’ (the goods and services that without which our health will decline and we will eventually die). This then leaves us with a discretionary disposable income with which to purchase those goods and services we want – and to do that we make decisions as to what to purchase so that we optimise our spending to acquire goods and services that have the greatest value to us. This element of choice, this discretion, means that we can choose to spend now or to save so that we can spend later (deferred expenditure). It also means we can choose to spend on goods that have no essential value but which satisfy an emotional need.
If we are rational, then we will seek to optimise our expenditure and only purchase those goods that are needed and present the greatest value to our long-term self-interest. This, of course, is the direct opposite of what the sellers of goods require us to do. The sellers (or retailers) are operating a business model that requires them to do everything they can to maximise the consumers spending – in other words, to get the consumer to spend the maximum possible amount irrespective of value or need. There is no possible situation in a consumer society in which a retailer can ever act in the consumers’ best interests as the economic objectives of the retailers and the consumers are mutually exclusive.
But why don’t consumers realise this? Why do they persist in believing that the offers from retailers represent something that will benefit them?
The answer is remarkably simple: people are not rational and seldom act in their own best interests. They are easily manipulated, usually by appeals to their emotions, and they seldom think things through to determine what course of action is actually in their real best interests. Essentially people are intellectually lazy, easily swayed by the opinions of others, and in many cases totally unable to think things through. This is where the work of Daniel Kahneman is of such importance. In his book Thinking, Fast and Slow, Kahneman explores the two types of thinking that appear to take place in the human brain. The dominant type is the Fast thinking (system 1) which creates heuristic models – experienced-based problem solving methods that use readily available information (and memories) that may be only loosely applicable and appropriate and usually render a sub-optimal (though often ‘good enough’) answer that contains systematic errors or cognitive biases. We tend to rely on these heuristics even when we shouldn’t, believing that our experience in similar such situations is appropriate in the current situation. This is simply not rational.
In comparison, the Slow thinking (system 2) engages in detailed analysis of all the information available to reach conclusions that a free of cognitive biases, systematic errors and requires consistent and conscious thought. It generally operates in a ‘bounded rationality’ but is still far more accurate than system 1, however it is an energy-intensive and costly process that takes significant amounts of time although it at least ensures that the subject is properly studied and a rational decision is made.
Why do we, as humans, allow our brains to adopt system 1 thinking at the expense of rationality? This is not explored by Kahnemen, possibly because the answer is not to be found within the field of psychology, but within biology. Studies show that an average human being has a resting metabolic rate of 1300 kcals per day (obviously this is dependent on age, gender, size and health, but this is an average) and the brain, which is about 2% of the body weight, consumes around 20% of that just to maintain its normal resting activity – about 260 kcals per day, but when the brain engages in system 2 thinking, the energy consumption increases dramatically and the amount of energy the body needs increases accordingly. This is empirically obvious to anyone who has been a student or has worked with students (or senior school pupils), at the end of a long day of study, they are exhausted and often fall asleep or need to consume high calorific foods before they can do their private study or homework – it is also measurable by studying blood glucose levels and other blood chemistry factors. Now, my hypothesis is that the brain has evolved in such a way that it has learned that deep thinking is costly in terms of energy and, as sources of energy are limited, it has set up decision-making and problem-solving methodologies (heuristic models) that make far lower energy demands while at the same time creating sub-optimal but ‘good enough’ solutions. In other words, our brains have evolved to use non-rational techniques as a way to save energy.
Obviously, if the system 1 heuristics are based on appropriate experiences, then they will become progressively more accurate in their outcomes and so less system 2 thinking has to be undertaken thus releasing the brain to engage in other activity without creating a spike in demand for energy. This, of course, is the basis of repetition or rote learning, repetitive practise, and our ability to provide ‘good enough’ solutions to most of our day-to-day activities. Kahneman builds on this by suggesting that when we do engage in energy-intensive system 2 thinking, the outcome can then be used from the memory and can inform the appropriate heuristic bringing its outcome closer to the optimal.
But Kahneman identifies something else that the brain does which makes our system 1 thinking sub-optimal and that is that the correct frames of reference for the problem, the understanding of risk and probability, and correction of our emotional biases are all active in system 2 but are not active in system 1. Such is our addiction to mistakenly believing that we are rational, we end up believing that all actions have an identifiable cause and if we can identify the cause, then we can control our response. But the shocking truth is that a great deal of what happens to us and in our environment is random in that there is nothing we can do to neutralise the cause or avoid the consequences. This school of thought is brought into clear focus by Nassim Nicholas Taleb whose work on randomness and risk is worth the effort (system 2) of reading and by ‘chaos theory’ which shows mathematically that very small differences in initial conditions (which may have existed at some indeterminate time and location in the past) can yield widely diverging outcomes in otherwise identical systems thus rendering long-term prediction of the outcome impossible. Both these concepts can and do invalidate the predictability which is a fundamental belief in micro-economics (and much else).
The truth of the matter is that behavioural psychology has undermined the foundations of micro-economic theory to such an extent that much of what we have been told is true about our economic activities is in fact unreliable. Take the prevalent and popular consumer model that is promoted so strongly by many societies, particularly western ones. This is, ostensibly, a market-economy model in which supply and demand play a dominant role so that rising demand for goods is matched by rising supply of those goods. But when we delve deeper, it becomes evident that the ‘market’ is a creation of the ‘supply-side’ elements – the producers and retailers – and not of the ‘demand side’ – the consumers. Let me explain.
During the world war that took place between 1939 and 1945, production was revolutionised, no longer were things made by artisans and by hand, machines were created and employed to mass produce the materials of war – everything from ammunition to aircraft were produced on a production line basis that churned out usable end products at a phenomenal rate. This was a classic ‘demand side’ situation: the military required huge quantities of everything and industry geared up to provide it. Costs were not a problem as governments simply printed money or the banks lent it and so production (a supply side element) knew no bounds. The problem was that after 1945/46 demand fell precipitously leaving the economy with a huge ‘over capacity’ on the supply side.
The solution, as far as the policy makers were concerned, was firstly to convert from the production of weapons to the production of consumer products (but involving the same technologies) and then to artificially create a demand via the promotion of consumption through advertising, marketing, bank loans, and governmental policy. Much of this was focused on creating a desire to own goods and services, irrespective of need, and the award of status for owning lots of material possessions. In other words, the creation of a consumer society to provide ‘demand’ for the over abundance of ‘supply’. Little attention was paid to whether these goods were needed, they were presented as being the rightful entitlement of the victors of the recent war: in other words, this was the reward for the privations and destruction endured. All the supply side actors were involved: banks lent money to consumers so that they could buy goods, producers made goods irrespective of need or value, advertisers and the media promoted the idea that greed was good and that owning lots of things was our entitlement and a desirable thing, that it gave us status.
Somewhat inevitably, there were just so many washing machines and other items that any one family could use and so producers started to build in obsolescence, they started creating products that were deliberately designed to break down after a certain period of time so that the consumer felt compelled to purchase a replacement – something that is certainly not in the best interests of the consumer and his or her need to optimise their economic activity, but certainly something that maximised the producers’ side of the equation. It didn’t take long for the consumer to become addicted to this bonanza of products and to create a huge demand bubble that was promoted by advertising and marketing communications in the media and fuelled by cheap loans from the banks.
Inevitably, these bubbles burst, lenders found themselves exposed to defaulting borrowers, many of whom should never have been allowed to borrow in the first place, greed had turned the lenders and the consumers into gluttons, more and more producers were entering the market thus inexorably inflating the supply side while squeezing the demand side by cutting off the supply of money that fuelled the consumer boom. Eventually, the consumers got the message that greed was NOT good, that the markets were a zero-sum game in which people could only obtain if someone else lost. It was not a win-win situation but a strictly win-lose with the consumer on the losing end. Eventually, the consumers stopped consuming, demand dried up and the supply side producers started to cry foul and pressurised their governments ‘to do something to stimulate demand’ – the governments, blinded to the reality of the simple win-lose equation and made up of normal non-rational thinkers, obliged and the result is the monumental mess the western economies are in as we enter 2014.
Bizarrely, governments are even telling us that we should not save our money (deferred spending) but we should spend now. These are the same governments that have no way of funding the pensions that will have to be paid and have been telling people to save for their own retirement. Well, rather obviously, we cannot spend now and save for our retirement … but there again, politicians are not known for their rationality.
Alasdair White is a business school professor, author and publisher. He is the author of three best selling management books and under his pen-name of Alex Hunter, the author of two thrillers.
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Author Alasdair White
There are times when I feel we need to question the ‘received wisdom’ to see if it is still properly based on a realistic and rational foundation. And when the US Treasury Secretary, Jack Law, recently called on countries, especially Germany, to boost economic growth via boosting consumer demand, I had a “that’s weird, let’s look at that again” moment.
There is a well known economic theory of efficient markets that is, broadly speaking, based on the idea that if the supply of goods matches the demand for those goods then everyone is happy and prices are stable, and if they are misaligned then either the price will go down as goods become abundant, markets might collapse and the suppliers become poor (too much supply), or prices will rise as goods become scarce and the suppliers will get rich (too much demand). But what is forgotten is that this is a ‘zero sum game’ in which there will be winners and losers, so let’s look at the theory the other way round. When the supply of goods is greater than the demand, then prices collapse as a result of greater abundance of goods and the consumer gets to save more of their money and so they become ‘richer’, and when there is too much demand, prices rise and the consumer has to spend more of their money for scarcer goods and so becomes ‘poorer’. Of course, the intrinsic value of the goods does not change in either scenario but the price does as suppliers manipulate it to maximise return – in other words, because they are greedy!
So, in simple terms, if the supplier is getting richer, the consumer is getting poorer; conversely, when the supplier is getting poorer, the consumer is getting richer. So if the supply and demand are not in balance, then is it better that the supplier gets richer or that the consumer gets richer? The answer to that is almost certainly that it depends on whether you are a ‘supplier’ or a ‘consumer’.
Because greed seems to be a fundamental of human economic behaviour, suppliers almost always try to manipulate the situation so that consumer ‘demand’ rises and the supplier gets richer at the expense of the consumer. What also happens is that government policy of whatever shade of political belief also tries to manipulate the situation to make the suppliers richer and the consumers poorer – the ‘poor’ are always far easier to control as they are often dependent on the government.
Now back to Jack Law. For most of the two decades covering the end of the last century and the beginning of this, we have been ‘demand’ led in that consumers have been demanding more and more of all types of goods – which they usually do not need and frequently dispose of before the end of their useful life – and paying for them with cheap credit that, six years ago, suddenly ran out. Consumers found themselves in severe debt and unable to pay it off while being equally unable to re-schedule their debts with new credit lines: having made themselves believe they were ‘rich’, consumers all over the developed economies were spending money they did not have and the dawning of reality has been painful.
During those same two decades, the suppliers of goods saw cheap credit as a cornucopia and grabbed it with both hands making huge sums of money in the process. And now that the credit taps have been turned off and ‘the consumer’ has realised they were living a false dream, the suppliers are hurting (read: going broke) and are demanding that ‘government do something’ to get the consumers to spend again: after all, they reason, the consumers are merely the tethered milk-cow to be milked and bilked out of their money for the benefit of the suppliers. Jack Law was merely doing his bit to help the suppliers make money and to keep the consumers poor, thus clearly positioning himself on the side of business and opposed to the good of the people.
The materialistic, consumer-driven society that exists in its purest form in the USA and almost as purely in the UK is a very individualistic, greed-driven and selfish model, and is neither in the rational self-interest of the consumer nor in the interest of the greater society. However, for the last half-century there has been an assumption amongst those who think they know what-is-what that the consumer society is the only viable economic model that will deliver growth and prosperity. But what has happened over the last six years is that the consumer has finally, perhaps irrevocably, discovered that consumerism using other people’s money is great fun, but when the owner of the money wants it back the result is extreme and sometimes insupportable pain: they have discovered that there is no such thing as a ‘free lunch’, and no such thing as a right to prosperity.
The trouble is, in societies that are not consumerist (the vast majority of the world) and are significantly less individualistic than the USA and the UK (see the work of Geert Hofstede), prosperity is based more firmly on supply and demand being balanced – thus in those economies, suppliers make and supply only what they can sell and consumers only buy what they genuinely need; everyone is happy with less but there is a more equal division of the wealth of the society. The balance is restored between the consumers and the suppliers, and neither is pursuing a ‘beggar thy neighbour’ policy.
But the USA, and to a lesser extent the UK, are finding the change very difficult, simply because it involves a fundamental change in attitudes, behaviours, and fundamental beliefs, leading to a profound change in the way the society operates. Instead of the unrestrained pursuit of personal gain at the expense of all others, Americans and Britons in particular will have to once again learn the value of cooperation with others – a cooperation based on trust rather than contract law; based on mutual interests rather than self-centred, self-interest; based on being a good neighbour rather than the bully boy on the block. There is plenty of evidence that, at the grass-roots level of ‘Everyman’, this is already happening: cooperatives are forming, and neighbour-help-neighbour groups, barter markets and the like are springing up. But this reality, this need to change, has yet to reach the company strategists, the corporate leaders and the governmental policy makers. Entrenched pork-barrels, fat-cat remuneration packages, and a gut-wrenching fear that they’ve been wrong all along are all contributing to an evident ‘denial of reality’ that change has to begin at home, that beggaring the consumer citizen for the benefit of the suppliers is not a viable or sustainable solution and that ‘the people’ have had a enough. Jack Law’s call for other countries to push up demand (essentially to push up demand for US goods) so that the USA need not change its ways is just the latest example of this sense of denial.
Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.
Author Alasdair White
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.