Seeing the light

Economists need to realise the importance of incorporating human emotion

 
David Orrell
November 6, 2012

In modern physics, one of the biggest conundrums is that most of the matter and energy that make up the universe is apparently undetectable. The amount that we can actually see equates to only four percent of the total. The rest of the cosmos is believed to be made up of so-called dark energy (74 percent) and dark matter (22 percent), whose presence we can deduce only through their gravity-like effects on other things, such as galaxies.

As so often in life, it seems that we only notice the small fraction of things that happen to be brightly lit, while the real action is going on somewhere else. A similar phenomenon occurs in economics. Economic models tend to focus on the relatively small part of the economy that is amenable to mathematical analysis – the rational, logical, utility-maximising part. But the economy is also driven by a number of factors which either create difficulties for our models, or elude them altogether.

Dark matter
The most obvious exception to rational behaviour, is of course irrational behaviour. The ancient Greeks may have defined man as a rational animal, but they were perhaps being generous. The financial markets continue to be driven in large part by emotions, such as fear or euphoria that are hard to quantify mathematically.

As I argue in my new book titled Truth and Beauty: Science and the Quest for Order, a number of other factors also contribute to the ‘dark’ content of the economy, and exert powerful forces that resist mathematical treatment. These include love, power, justice, money – and everything else.

Love: Much of our sense of wellbeing comes from social relationships, but this is not reflected in economic metrics of utility. Tasks such as looking after the young, old, and sick – which are still mostly performed by women – are often paid poorly or not at all, but are nonetheless vital to the health of society. They say that money makes the world (and the economy) go round, but love definitely plays a role as well.

Power: Neo-classical economics treats individuals and firms as more-or-less identical atoms. If people behave like rational economic man, that means they will all make the same rational decisions and have approximately the same advantages. As Norbert Häring and Niall Douglas observe in their book Economists and the Powerful, however, the economy is characterised by complex power relationships, such as, for example the power held by corporations, governments, rating agencies, financial institutions, and so on, which are downplayed or ignored by mainstream models.

Justice: As Czech economist Tomáš Sedláˇcek notes in his book Economics of Good and Evil, the invisible hand (usually attributed to Adam Smith, though the idea is much older) is assumed to provide a reasonably just distribution of wealth. As a result, “ethics has disappeared from mainstream economic thought.” Growing levels of inequality have become a global issue. Excessive concentration of wealth in the hands of a few violates our basic sense of fairness, with destabilising effects on society and the economy.

Money: One of the stranger features of mainstream economics is that money doesn’t seem to play much of a role. For example, most General Equilibrium Models – of the type used, for example, by the Bank of England – don’t include things like banks or hedge funds. This makes it hard for the models to understand, let alone predict, phenomena such as the subprime financial meltdown or the ongoing euro crisis.

Everything else: Finally, mainstream economic theory fails to pick up an even larger source of dark matter and dark energy, which is everything outside the monetary system, including the Earth. The environmental crisis is a byproduct of our economic system; but because it is hard to model things like resource depletion, environmental damage, or the beauty and diversity of nature, these barely even register in most economic models.

So how can economists come to grips with these various sources of dark matter or dark energy? Some progress has certainly been made, mostly in so-called ‘heterodox’ fields. Behavioural economists, for example, have helped to illucidate the effects that ‘bounded rationality’ has on markets. Feminist economists such as Lourdes Benería have explored the roles of power and gender in the economy. Hyman Minsky alerted us back in the 1970s to the inherent instability of the financial system. Ecological economists such as Herman Daly have long pointed out the absurdity of treating the economy as independent of the world system.

The human touch
One reason that these areas remain ‘heterodox’ is that they do not fit easily into the mathematical framework of mainstream economics. So perhaps to become more realistic and objective, economics must actually become less attached to abstract mathematical arguments. When economics was founded in the late nineteenth century, it was explicitly modelled after the ‘rational mechanics’ of Isaac Newton.

After losing much of his fortune in the South Sea bubble, though, Isaac Newton wrote in 1721 that: “I can calculate the motions of heavenly bodies, but not the madness of people.” Today we are learning that in many respects, the economy behaves less like a deterministic, Newtonian machine, than like a kind of super-organism. In other words, it’s alive. So to understand it we need to use the right kind of mathematics – i.e. areas such as complexity and network theory that are adapted for living systems. And we also need to know and respect the bounds and limitations of mathematical models, and bring areas that are less amenable to mathematical treatment back into view.

In physics, it might not make much difference to our everyday lives if we ignore the effects of dark matter (it is unlikely to hit us on the head). But with the economy is being driven by forces that we cannot predict, control, or often even detect until it is too late, hard hats are advisable.