Efficient Markets or Herd Mentality? The Future of Economic Forecasting

Ever wonder why you succumbed, yet again, to advertising hype or deceptive packaging and overpaid for a product? Or bought securities that you know were overvalued when the herd instinct was just too strong to resist?

Such irrationality is the focus of behavioral economists, who appear to be gaining greater credibility in macroeconomic circles since the housing bubble of 2008 and the ensuing global financial meltdown. They are also at the center of an age-old debate recently reignited by columnist and Nobel laureate Paul Krugman in a September 6 New York Times Magazine article titled, “How Did Economists Get It So Wrong?,” which fires a salvo at the assumption underlying neoclassical economics — namely, that free markets are inherently rational and efficient.

Krugman’s article heaps scorn on so-called “freshwater economists” — as typified by the University of Chicago economics faculty, whose ideas have dominated government policymaking since the early 1980s. In contrast, “saltwater economics” exhibits more openness to the ideas promulgated in the 1930s by Britain’s John Maynard Keynes — that free markets often behave inefficiently, are self-destructive and at times need corrective policy actions such as government stimulus spending. Rather than ascribing perfect rationality to markets, these economists say people and institutions often behave irrationally and often in ways contrary to their own interests.

While the debate between the freshwater and saltwater viewpoints in macroeconomics may sound academic, it has a significant impact far outside the ivory towers of universities. First, companies rely on macroeconomic forecasting in their strategic planning and budgeting and for gaining insight about customers and competitors. And macroeconomic theory underlies much of government policymaking. Since the late 1970s, for example, the U.S. government’s deregulation of airlines, banking, utilities and communications grew out of a tacit belief in market efficiency and rationality. The Obama administration may be the first to seriously challenge efficient market assumptions since the Reagan era of the 1980s, amid its attempt to restrain executive compensation and set up a new consumer protection agency to govern credit and debit card practices.

The debate isn’t limited to the U.S., either. This year’s Nobel Prize in economics was awarded to Elinor Ostrom of Indiana University, a political scientist, and Oliver E. Williamson of the University of California, Berkeley, an expert in conflict resolution, striking many economists as an international rebuke of the rigidly mathematical, rational-market models. “It is part of the merging of the social sciences,” Yale University economist Robert Shiller told The New York Times, echoing elements of Krugman’s argument. “Economics has been too isolated, and these awards are a sign of the greater enlightenment going around. We were too stuck on efficient markets, and it was derailing our thinking.”

A good read - via Efficient Markets or Herd Mentality? The Future of Economic Forecasting – Knowledge@Wharton.

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