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The economics of wishful thinking and the adventures of rationality

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Abstract

Replying to Queen Elizabeth II who in November 2008 asked why so few economists had warned about the emerging financial crisis, a group of eminent economists of the British Academy, claimed that while this failure had many causes, the most important was principally a failure of the collective imagination of many bright people, to understand the risks to the system as a whole. The paper suggests that this failure is due also to the still heavy influence of the paradigm of rational expectations, that did not provide the intellectual tools to grasp the signs of the impending financial crisis. The paper explores the development of Muth’s rational expectations hypothesis and the parallel development of Simon’s idea of bounded rationality—two opposite views about economic behavior that originated in the same context, during the early 1960s at Carnegie Mellon. It is shown that the latter, while marginalized for decades from the core economic ideas, generated a wide development in cognitive psychology, problem solving and experimental economics that grew up in the last decades and now permit a more profound analysis of human behavior in economic and organizational contexts, that can be the seed of a new thinking in economics. The challenge for economists is to use this new toolbox to incorporate in their models real human behaviors, getting out from the economy of wishful thinking.

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Notes

  1. Minsky (1992)

  2. Muth (1961), p. 315.

  3. Shiller (2003), pp. 83–84.

  4. Simon (1991), p. 250. The relations between the two theories and a very interesting analysis illustrating Muth's move from bounded rationality to rational expectations and back again, are documented in an interesting article by Esther-Mirjam Sent (2002).

  5. Friedman (1953), pp. 13–14.

  6. A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted.

  7. See for example Hommes,(2006) Chapter 23.

  8. March and Simon (1958).

  9. Chase and Simon (1973).

  10. Even though the existence of a best strategy can be mathematically demonstrated.

  11. Levinthal (1997), p. 935.

  12. besides the more technical assumptions of completeness and continuity.

  13. Tversky and Kahnemann (1987), p. 88.

  14. Kahneman and Frederick (2002)

  15. i.e. in a form interpreted as i.e. as prescriptions related to a norm, as obligation, prohibition, permission,etc.

  16. Gigerenzer and Hug (1992).

  17. Barberis and Thaler (2003), p. 1113.

  18. Ritter (2003), p. 6–7.

  19. Hommes (2001), p. 150.

  20. De Long et al. (1991).

  21. Besley and Hennessy (2010)

  22. Shiller (2003), p. 102.

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  1. LUISS Guido Carli, Viale Pola 12, 00198, Rome, Italy

    Massimo Egidi

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Egidi, M. The economics of wishful thinking and the adventures of rationality. Mind Soc 13, 9–27 (2014). https://doi.org/10.1007/s11299-014-0146-8

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