Editor’s note: this column was originally published on August 29, 1999.
Just how rational and well-informed are human beings? What happens to economic theory if people are not always rational and often poorly informed?
These questions are prompted by a recent car-shopping expedition together with a column written by my fellow Armchair Economist, Tim Kehoe, in the Aug. 1 Pioneer Press.
In that column, Dr. Kehoe pointed out that David Ricardo had analyzed the situation that the United States now faces. That is, what is the best policy to follow when taxes exceed current revenues, but the nation has a large debt? Is it best to cut taxes so as to give households more to spend and invest? Or should the government keep taxes at current levels and use any surpluses to pay down the national debt?
Ricardo’s somewhat surprising conclusion is that it makes little difference. If the government cuts taxes, rational people will know that a large government debt will exist in the future. They will thus increase their savings so as to have funds available in the future, when taxes are raised.
That is the rational human behavior posited by Ricardo, one of the most brilliant economists of all time. But do people really act that rationally?
Listening to commercials for “tax rebate sales” on TV recently and watching people crowding automobile show rooms last night made me pause. Are people really making a judgment that more cash in hand now may mean higher taxes later? I doubt it.
Ricardo’s logic is impeccable, given his assumptions. And Kehoe carefully showed reasons why actual human behavior might be different from that assumed by the great Englishman.’
But the question remains whether the broad assumptions of near-perfect knowledge and rational behavior that underpin most economic theory ever are safe assumptions.
In many ways, Ricardo’s analysis foreshadows the rational-expectations hypothesis of John Muth, broadened and developed by Nobel Laureate Robert Lucas and by three economists with Minnesota connections, Thomas Sergeant, Neil Wallace, and Edward Prescott.
Rational expectations theorists argued that the discretionary economic policy actions advocated by Keynesians were doomed to failure because rational, well-informed people would automatically take self-interested actions that would counteract whatever the government was trying to accomplish.
While not all economists today would call themselves “rational expectationists,” the theory has been hugely influential within the discipline. Rational expectations theory depends on the assumption that people are well-informed about economic and political affairs and that they are rational.
But study after study, including one published just a few months ago by the Federal Reserve Bank of Minneapolis, concludes that the average American, even with a college education, is woefully misinformed about economics and U.S. economic policies.
More specific studies on public knowledge of Social Security and retirement issues also reveal great gaps in public understanding of how Social Security works and what sorts of funds people will have for their retirement.
Then consider the people out in the malls and car showrooms, spending furiously even as some economists argue that national savings rates have to increase dramatically for baby boomers to have some claim on income when they retire.
Are these the rational economic agents, assumed by Ricardo and other economists, carefully making judgments about future conditions? Or are they responding to the pressures of our society and culture?
One of the best ways we economists can keep things in perspective is to read the writings of economists who were prominent 50, 100, and 150 years ago. Some of their ideas have stood the test of time and are still relevant. But others strike us as silly when we read them.
Our grandchildren’s generation will do the same with our work. Some parts will merit their respect, while other parts will bring scorn or contempt.
The great economist Adam Smith believed firmly in the labor theory of value – that is, the value of a good was determined by the amount of labor that went into it. Most economists of his generation did so. Karl Marx came later and twisted this labor theory of value into an intricate model of exploitation, impoverishment and ultimate revolution.
But at the same time, other mainstream economists were finding better ways to explain value. Today, only die-hard Marxists in fields such as sociology and literature still believe in the labor theory of value. It is nearly impossible to find an economist who does.
In the same way, economists in the year 2099 may look back at us and chuckle about our obsessive assumption of rational and well-informed decision-making by ordinary people. As an economist, it would be wonderful to be able to go “back to the future” in a time machine just to see what what those who follow us will think of us.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.