The Macro Doubtbook, Installment 10
The previous installment was here. The installment below covers behavioral economics.
Recall that the ultimate approach in the Doubtbook will be to stitch together the history of macroeconomic thought with the history of macroeconomic episodes. The opening chapter looks at all of the different sub-fields of economics that macroeconomists turn to for their theories. We are still in the opening chapter.Behavioral Economics
In frictionless markets with optimizing behavior on the part of individuals, one would not expect to see unemployment. I think of behavioral economics as studying deviations from optimizing behavior. Non-optimizing behavior could itself account for macroeconomic phenomena. In addition, non-optimizing behavior may help to explain market frictions.
For example, Animal Spirits, by George Akerlof and Robert Shiller, places heavy emphasis on behavioral economics as the source of economic fluctuations. They claim the mantle of behavioral economics for Keynes, or vice-versa.
One of the puzzles of macroeconomics is the fact that downturns produce an excess supply of labor, rather than a reduction in wages. Many explanations for this rest on psychology. For example, there is the “efficiency-wage” theory, which says that the quality of work effort is positively related to wages. Firms are reluctant to cut wages in a recession because they believe this will reduce effort.
Akerlof and Shiller offer the theory that workers care about fairness. Workers may perceive a cut in wages as unfair, and they will resist such an approach.
Even though one firm may resist wage cuts, in a dynamic market wages might go down, anyway. For example, suppose that there are two firms in the same industry, one of which uses low-skilled workers at low wages and the other of which uses high-skilled workers at high wages. Even if each firm’s wages are fixed, in a recession some high-skilled workers might shift to lower-wage jobs, reducing the average wage. However, they would not make this shift if they perceive that lower wages are unfair, given their skill level.
Another idea is that if firms cut wages, they leave the choice of who leaves the firm up to the worker, and the firm may lose its best employees. Instead, using layoffs gives the choice to management, so that the best employees can be retained. However, this raises the question of why a firm would lay off its least valuable employees, rather than selectively cutting their wages. Again, one may wish to appeal to the behavioral economics notion that workers would see selective wage cuts as unfair, and this would hurt morale. If you selectively fire workers, their morale is damaged, but they are gone. If you selectively cut wages, the workers whose morale is hurt are still around, perhaps reducing everyone’s productivity.
However, again consider a dynamic economy with many firms. If some firms lay off workers, then in theory new firms can enter, offer low wages, scoop up cheap labor, and earn high profits. Explaing why this does not occur might require really stretching the behavioral economics story.
Akerlof and Shiller also invoke behavioral economics to explain booms and busts. Individual expectations for returns on assets are naively based on recent past returns. That creates strong momentum in asset prices, leading to bubbles and panics.
Keynes himself offered a more subtle view of animal spirits. He suggested that the future is not knowable, and entrepreneurs must decide how to proceed even though they lack vital information. When their mood is optimistic and aggressive, they invest heavily. When their mood is pessimistic and defensive, they scale back their investment. Again, one wonders about how this works in a dynamic market. If some firms are cutting back investment in a recession, then the low cost of capital creates opportunities for other firms to undertake profitable investment. Why does this not occur? Keynes would say that it is because pessimistic expectations about the future override the low cost of capital.
If some individuals behave irrationally, then what we have seen is that other individuals tend to have profit opportunities. If profit opportunities go unexploited, then I would argue that there must be some market friction. Therefore, my view is that we need more than just behavioral economics to explain macroeconomic phenomena. We will need to understand market frictions, whether or not we also include systematic non-optimizing behavior in the story.