The economy erupted in 2007 unexpectedly, and has been a debacle ever since. Economists were not able to to forecast the volcano-like eruption of the economy. While scholars have earned degrees and numerous economic theories have been formed, why were Economists not able to predict this nasty recession and warn monetary-policy makers?
Professor Robert J Shiller of Yale tells us it all comes down to assumptions. In standard economics, we have models assuming that humans act rationally. In a perfect world, with perfect people, the recession or the “bubble” would never occur. However, in our less-than-perfect world we face several ambiguities, and people do not always act rationally. Our current theories assume that, “all people behave as if they knew all the probabilities and did all the appropriate calculations (Shiller, 2009).” We speculate prices in various markets until the prices crash dramatically. Shiller says, “Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases (Shiller, 2009).” In our standard economic models, the assumption is that the only factor that influences human’s decisions are the facts and rational probabilities, which is of course invalid.
In another branch of economics, behavioral economics, psychology plays an essential role. Research indicates that we do not satisfy the axiom of rationality. We assume that each time will be different, and do not rely much on probabilities and rational statistics. Though the axiom that we are rational people, may be applicable to microeconomic issues, on the macroeconomic scale it is not applicable.We can now conclude, “that different parts of the brain and emotional pathways are involved when ambiguity is present (Shiller, 2009).” Totally rational people definitely would not be buying Louis Vuitton bags, when similar bags are available for a tenth of the price- too bad we’re not perfectly rational.