14th Sir Arthur Lewis Memorial Lecture 4 November 2009 Sir Cecil Jacobs Auditorium, ECCB Headquarters St Kitts and Nevis
Those studying economics or finance in recent decades will all have been inculcated with certain models of economic behavior. We learn to formulate models based on predictable and efficient behaviors. This allows us to aggregate individuals and firms and to mathematically find optimal solutions. The greater the degree of behavioral certainty underlying these models, the easier the modeling becomes, the greater the sophistication, and yet the further from reality we move. I recall in graduate school hearing a fellow PhD student present a thesis on optimal spatial use in urban economics assuming the city was a straight line! Good for modelling, not so useful in real life.
In the world of policymaking this meant that governments were asked to get out of the way so markets could do their magic.
In the aftermath of the fiasco of the combined housing, stock market and real economy collapse, we now can see more clearly a whole set of facts that make this fascination with financial sophistication and efficient markets rather flawed.
Let's start with the assumption of the rational consumer.
Behavioral economists like Cornell's Robert Frank frequently point out that when individuals are offered a choice of a 4,000 sq. ft house in a neighborhood of houses averaging 3,000 sq ft. or a 6,000 sq ft. house in a neighborhood of 8,000 sq. ft. average, the majority of those polled prefer the smaller house that bests their neighbour’s. Is this rational?
Was it rational for homeowners to take mortgages they couldn't afford? Yes, perhaps they were
duped and perhaps they were uninformed, but similar to borrowing money on credit cards, this is not the rational economic agent that micro textbooks depict. And these are not the rational actors assumed in our regulatory regimes.
So we have a disconnect between the theory of markets and the marketplace itself.
Behavior towards and risk tolerances are similarly distorted because how else can we explain sub-prime mortgages or banks not calculating the interaction effects of poor economic outcomes. Perhaps the thought of government bailouts is comforting in a perversion of moral hazard, but perhaps it is an irrational discounting of future risks. After all, in many circumstances, once the problems arise, it's usually someone else's problem to clean up the mess. That's how it often was in the World Bank and we tend to think accountability there exceeds that on Wall Street!