Following the crisis, many economists and methodologists have argued that more realistic behavioral underpinnings of economic theory would have made forecasts more accurate. Do you think that one of the things the recent crisis has shown us is that people just do not behave rationally? Or did the crisis rather show exactly the opposite—that people did in fact react to incentives and that the consequences of introducing new financial instruments were just not foreseeable?
I think it is mainly the latter. There were incentives, both on the borrower and on the lender side, that these subprime loans would be made available at the lowest interest rates; and there was pressure from the government to do so; and probably those involved did not understand the financial instruments. Now, is it that we have to change our theories radically with respect to their behavioral structure or even switch to a new behavioral framework? There is very little evidence that would support such a move.
There is a whole field of behavioral economics that I follow pretty closely, and parts of it I have even contributed to. But did the behavioral economists predict the crisis any better? When taking a look at the literature, one does not find better results. The rational choice model is an abstraction and as is the case with all abstractions and all theories from whatever discipline, say physics, you abstract from some things that sometimes may be important. And this is also true of the rational choice model. In terms of understanding the crisis, I do not think that more realistic behavioral assumptions would solve the problem. It has always been difficult in rational choice models to adequately account for the coordination of people’s expectations. To some extent, the crisis involved the coordination of irrational expectations. This might be something we should think about and improve.
With respect to how the crisis affects our models in terms of being based on a more realistic assumption structure: what will occur is that models become refined to help us understand what happened. But I do not see a fundamental change in the models with respect to the underlying structure of human behavior, nor do I see a need for such a change.
Tuesday, 12 June 2012
Posted by Paul Walker at 8:57 am