Theory versus Behavior – Does One Size Fit All?

Introduction

What does ‘theory’ mean for us? Most widely, it is the set of rules, principles, and models reasoning an action based on assumptions that rationalize the decision-making environment. Theories and models have historically formed the basis of every phenomenon and their understanding is regarded as the basic requirement of our knowledge intensification. Nonetheless, theories have exceptions! The laws of demand and supply drive a market but aren’t there exceptions to these laws? There are, and equally vital to understand the market functioning as the laws. Why did the exceptions arise? My two cents – mainly because of insufficient conditions for the laws to hold good. Aren’t exceptions also an outcome of un-hypothesized reaction of the respondent to an action, amongst many other reasons identified? Does human behavior play a role here? After all, behaviour is dynamic and exclusive to every individual and given that, it may be uncertain and irrational too!

Summary

Drawn on the book titled ‘The End of Theory: Financial Crises, the Failure of Economics and the Sweep of Human Interaction’ by Richard Bookstaber, my article broadly discusses the dubiety in applying economic theory or behavior for solutions to issues. The book, published in 2017, essentially deliberates the infamous financial crisis of 2007-2008 as a disaster for the global economy for, the economic theories and models developed hitherto in the classical and neo-classical era failed to predict the crisis. Why so? The author argues that every crisis and its reason is unique. Hence, the corrective measures taken to recover from the previous crisis may not be applicable and may not help alleviate the forthcoming one. Commonly suggested measures like diversification and hedging fail and even quantitative analysis doesn’t matter. `Spotlighting the significant role of uniquely human behavior, the book deliberates that the human interactions and experiences in different situations are difficult to understand and are hardly quantifiable. Taking cues from the concept of reflexivity by Soros in an economic scenario, he explains that based on the observations of the economy, human behavior changes which, in turn, leads to further change in the economy. Since the human reaction to economic change is uncertain and situational, the consequential changes in the economy are deterministic. This situation contrasts with complete rationality assumed by the traditional, classical, and neo-classical economic theories, wherein the optimization models assume full information in the system. Humans receive only the information which helps them to work in their best interest. Availability of limited information constrains as well as enables adaptive behavior enabling new functions. Excessive or complete information and more cognitive processing can actually do harm to an individual/investor in the economy.  This argument holds up to the idea of complexity in human behavior. Further discussion on this complexity and the interaction between the individuals and the economy has been manifested using the following Four Horsemen :

  • Emergent Phenomena
  • Non-ergodicity
  • Radical uncertainty
  • Computational Irreducibility

Can you think of an imp who’s up to some prank while the guardians are clueless and even the kid having no inkling of the consequence? Emergent phenomena is a state where even though no one is directing an action, the end result of an event can be a catastrophe because of unexpected actions of individuals. That is because the overall effect of the individuals’ actions is different from what the individuals are doing. These individual actions lead to system-wide unexpected dynamics which is known as emergence. No one causes those phenomena, but it still occurs. 

Every interaction and reaction by an individual is contextual and is based on the individuals experience and the frame of mind. The probability of recurrence of any state is less likely- non-ergodicity. Both emergent phenomena and non-ergodic processes put together cause radical uncertainty. As humans, inconsistency may influence our actions as much as creativity or inventiveness leading us to a point we never expected. The unanticipated future outcomes and complex social interactions lead to inexplicable uncertainty. 

Hence proved…is what we conclude as the solution for a problem involving mathematics and based on traditional economic models. Social interactions are far more complex and mathematics cannot explain them. That’s what computational irreducibility means! An individual needs to live in time to know the outcome. Alternatively, they need to run periodic simulation exercises to extract system-level conclusions from individual behavior. The book terms such applications as agent-based modelling. It has been projected as a very significant replacement of mathematics based standard theories of economics. Agent-based models analyze situations based on the complexity of human interactions. The models are adaptive to people’s own course of action and their limits, one of the core reasons for the failure of traditional economic models. They do away with the intense complexity in the economy arising out of human interactions. The book exclusively illustrates the applicability of the model in financial markets by modelling the players of the financial market- bank dealers, hedge funds, etc. and also the heuristics they use in making financial decisions. The integration of the environment in which the players interact with the model is essential for the success of the model. 

Interestingly, the author also discusses how agent-based models would have given insight into the Crash of 1987 and the Flash Crash of 2010. 

Discussion

Over a period of time, behavior and its study has found inroads in decisions pertaining to financial markets.  As any other theory, even the behavioral patterns have been theorized and integrated into economic theories for better analysis of uncertain conditions. Their timely synthesis with the conventional theories may have saved the world this mammoth loss. Though the author argues rationality, and solutions based on rationality as a mirage, in my opinion, it cannot be overlooked in the real world scenario. Rationality, at a level, forms an integral part of an individual’s behavior hence, an individual cannot abandon it completely. In line with this understanding, economic theories based on rationality are significantly important and should be used within their limitations. They provide a base for the development of the concepts of behavioral economics. The book, in its entirety, has not provided any technical solutions for dealing with financial crises but has made readers aware of the possible limitations of standard economic models in realistic situations and has provoked thoughts about finding out possible solutions for these uncertain, complex situations by harnessing the human behavior- their interactions, experiences, and heuristics in the design of the agent-based models. The illustrations are convincing enough to support the suggested agent-based model for forecasting crises in financial markets. This impresses upon the reader that the economic system is primarily identified with financial markets. What I found missing here is the discussion of any of the macroeconomic variables of an economy like productivity, inflation, unemployment, etc. around the arguments related to optimal mathematical models and even in suggestions of a more realistic approach. Hence, the analysis provides a limited basis for refuting the importance of traditional theories. 

Key Takeaways

  • Traditional economic theories, in their understanding of the world, did not indicate that no solution was available for a crisis, rather, the methods of the economic theories were “not up to the task”. This is a representative agent model which assumes that all humans are encompassed together as a representative of the economy; they are not considered as separate individuals with varied behaviors. 
  • The theories in the neo- classical era also could not anticipate the threats of an ensuing crisis since they were designed assuming a normal situation in the economy with least unpleasantness. It was a given that all those assumptions which the theorists drew would always hold well. He strongly objects any consideration to human behavior in various economic situations and emphasizes that this was the primary reason for non- predictability of the crisis of 2008.

Further Readings

  • Bookstaber, Richard (2017) The End of Theory: Financial Crises, the Failure of Economics and the Sweep of Human Interaction, Princeton University Press.
Vikku Agarwal
Research Scholar- Jain University, Bangalore; Faculty- International School of Management Excellence