Do people make rational, logical economic decisions? That is what has been assumed by economists for many years. As David Brooks puts it in his NYT column today:

Roughly speaking, there are four steps to every decision. First, you perceive a situation. Then you think of possible courses of action. Then you calculate which course is in your best interest. Then you take the action.

Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest.

Anyone who has been in the market for any length of time knows this isn’t true of course. Irrationality was rampant during the internet bubble and again during the housing bubble. As Brooks points out, Greenspan, in his recent Congressional testimony, expressed surprise that markets didn’t work as he expected. Bankers didn’t act as he expected:

But during this financial crisis, that way of thinking has failed spectacularly. As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

Brooks believes that the newish field of behavioral economics will provide us insight into the economic thinking of individuals:

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Brooks, like so many others, takes this as an opportunity to bash markets (although he redeems himself somewhat by also pointing out that politicians are worse):

If you start thinking about our faulty perceptions, the first thing you realize is that markets are not perfectly efficient, people are not always good guardians of their own self-interest and there might be limited circumstances when government could usefully slant the decision-making architecture (see “Nudge” by Thaler and Cass Sunstein for proposals). But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they’re even more likely to filter inconvenient facts.

This meltdown is not just a financial event, but also a cultural one. It’s a big, whopping reminder that the human mind is continually trying to perceive things that aren’t true, and not perceiving them takes enormous effort.

What Brooks, Greenspan and so many others leave out of this critique is that the market was distorted. In fact, Greenspan did the distorting. Is it any wonder that bad decisions were made when the Fed distorted the market? Individuals and institutions made decisions based on a false reality provided by the Fed’s manipulation of interest rates. If those distortions had not happened, the decision making process would have been better. Don’t get me wrong; people don’t make purely rational decisions when it comes to economics, but they would be orders of magnitude better if the Fed didn’t try to alter the reality of the market.

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