I recently read an article
by the Nobel Prize-winning economist Paul Krugman in which he described
the renewed battle between so-called freshwater economists (so named
because they are largely based at the University of Chicago and other
Midwestern universities) and saltwater economists (based primarily at
Princeton, MIT, Berkeley and other coastal universities). The
freshwater economists are disciples of Adam Smith and espouse the
free-market and rational actor models. The saltwater economists align
with John Maynard Keynes and his belief in the need for regulation in
financial markets and that people aren’t rational actors.

The past 50 years have been dominated by freshwater economists who
had a reverential faith in the power of free markets (Smith’s
“invisible hand”) and the rationality of people in their financial
decisions. Given what has happened to our economy in the last decade,
noted for its multiple bubbles (e.g., Internet, housing, mortgage),
it’s hard to believe that any of these “efficient market” adherents
still have jobs, much less credibility in how the economy actually
works.

I would love to put these economists on the couch and explore what
is going on in their heads that enables them to observe the objective
reality of the recent economic devastation, yet still hold as sacred
their most basic, yet obviously flawed, beliefs about a
free-market-driven financial system.

As I have read more about the Smith followers, what seemed like pretty obvious questions kept popping out of my head:

• What universe do these people live in?
• Do these economists live in complete isolation without interaction with actual human beings?
• Have they never been in love, been gambling, or had sex?
• Have they never seen people get angry, frustrated, depressed,
  excited, or joyful and then observed their subsequent behavior?

If we ever had answers to these questions, we would understand the how
of their devotion to an economic mindset that is clearly not supported
by economic reality. These questions then led me to ponder the why of their delusional dedication:

• Are these economists such number-crunching automatons that they
  never even consider actual human behavior in the real world of finance?
• Are they so doctrinaire as to miss the obvious?
• Are they so enamored of the sheer elegance of their mathematical
  theorems that they reject outright and without consideration what is
  obvious even to laypeople?

What I find ironic is that, by rejecting the irrationality of human
behavior, they are in fact affirming its irrationality. To see
ourselves as rational beings is the epitome of irrationality.

Of course we aren’t rational, and you don’t need a Ph.D. to realize
that (though an advanced degree from the University of Chicago seems to
have the opposite effect). Human beings, for all their cerebral
development, still act most of the time the way animals and humans have
for millions of years, namely, as irrational, unpredictable, and not
particularly intelligent creatures.

What I find so remarkable is that there is any debate at all. As a
former psychology professor of mine once noted, “All psychology does is
label things that we already know to be true.” In the Bizarro world of
freshwater economics, that adage would be modified to, “All economics
does is reject things that we already know to be true.”

Thankfully, the emerging field of behavioral economics, which is the
melding of psychological and economic thinking, has generated a growing
body of research demonstrating that we are, in fact, incredibly
irrational beings who act in ways that are not only poorly conceived,
but that are often counterproductive and sometimes even
self-destructive. Examples of such irrational behavior can be found in
a variety of well-researched cognitive biases (courtesy of
Wikipedia.com):

• Bandwagon effect: we believe or do things because others believe or do them.
• Confirmation bias: seeking out information that supports our beliefs.
• Illusion of control: our belief that we have more control over outcomes than we actually do.
• Déformation professionnelle: looking at things through the lens of
  one’s profession while ignoring broader perspectives.

The last cognitive bias seems particularly fitting for freshwater
economists who seem to have been so busy developing their fancy
theories in their laboratories that they forgot to look outside and see
what was actually happening in the real world. The list of cognitive
biases that we succumb to goes on and on with most having direct
implications for understanding our financial behavior.

Finally, it is instructive – and scary – to consider the degree of
hubris or denial on the part of the freshwater economists, whom I would
assume are very intelligent men and women. They continue to cling to
now-discredited theories, even when confronted with overwhelming
experimental and real-world evidence that demonstrates what just about
everyone else in the world can see with their own two eyes: humans,
including economists, are not rational!