Since we said 'traditional', let it be the third than the first one, so that it goes with the meaning of 'traditional'. With the global crisis, criticisms of chief economists about economic theory have peaked. I am addressing this issue for a while now; I used not to write 'Sunday's commentaries in the past', but it seems that I will develop such a habit at least for a certain while. And this is also a 'Sunday's commentary'.

I have talked about the new book of Akerlof and Shiller. They both are among well-known economists. The former is also a Nobel Prize winner. Name of the book is 'Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for the Economy?' (by Princeton University Press). In the presence of ambiguity and uncertainty, human behaviors can reach extreme ends. They sometimes show inaction whereas they in other times they can take enthusiastic action rather than inaction. As far as I am concerned, this phrase was introduced into economy theory by famous economist Keynes. Authors of this book in a similar fashion argue that we cannot understand economic modus operandi and thus offer a prescription unless we understand how people channel their ideas, emotions, and passions.

Severe criticisms against Keynesian economics since 1970s gave way to the birth of a new economic school. We can call this the neoclassical school the roots of which are based on the classical school present before Keynes. They use a highly developed set of mathematical and statistical models. It will not be wrong to argue that they have put their mark on the economic theory. Of course there are other economists who think outside the neoclassical economists and who were recently awarded Nobel Prizes with their recent studies. What I am talking about here is that the neoclassical school represents the mainstream and that the research agenda is set to a large extent by this school.

Mainstream economic theory is mainly based on market economy. Economy working under the free market principles can reach equilibrium alone as economic units (consumers, firms) pursue their own interests and act rationally when doing so. That is, they never act in accordance with their emotions or desires. Therefore, this school believes that there is no need for state intervention. For example: as a result of the global crisis, unemployment in market economies have jumped. Mainstream theories argue that economic policy makers must not intervene but wait until unemployment rate is reduced back at the natural level under the normal course of the economy. On the contrary, they argue stat state intervention will make things worse.

Akerlof and Shiller criticize this view. They argue that people not always pursue their interest when making their decisions but also base their decisions on their feelings, passions, or rumors. For instance, if the rumors said "Look how rapid housing prices increase. We should get a loan and buy a house as soon as possible. After all, investing in housing is always profitable" demand for houses can go up. Volume of housing credits increases; housing credits are packaged and excluded from the balance sheets of credit extending institutions. Therefore, the risk is transferred between different people. As you do not bear the risk but at the same time earn a commission over the credit you extended, you try to find a 'smart head' to give a loan to. You extend credits to even those who are not creditworthy. So, housing prices increase further. Then, the rumor gains grounds and spreads around further. After that, demand for housing and housing prices go up again. Nonetheless, no one recognizes that housing prices cannot increase forever.

In this sense, a decision making behavior which is not rational but based solely on rumors take precedence.

There is a field called behavioral economics. This field carries out various experiments as well utilizing the psychology and examines the decision making behaviors of economic units. Authors provide some examples for such experiments. For example tax a region which received dense snow for days. Of course, demand for shovels goes up in the region. Subjects are asked their opinion about a rise in the sales prices of shovels. A substantial part of the subjects say that a rise in prices will not be 'fair'. And this is not a rational decision making behavior in the pursuit of one's own interests.

The authors do not claim that economic units do not make rational decisions. What they say is they cannot act rationally all the time and they are sometimes guided by non-economic instincts. The authors argue that economic theory must be reconstructed taking such behavioral types into account. To solidify this argument, they ask eight important questions about the economy in the second part of their book (for instance, why are there people who cannot find a job? Why do economies fall into depression?) and they state that these questions can only be answered going beyond the framework of rational and self-interested behavior patterns.

I strongly recommend this book. After you read the book, you can also take a look at the critics about it. R. Farmer, who will publish two different books on the same subject in February and March from Oxford University Press, provides a critical review at his own website. Farmer also thinks that economic theory must be revised completely; but he also believes that Akerlof and Shiller have gone 'too far'. Farmer is among the first economists to analyze, using the same techniques with neoclassical economists but going beyond the neoclassical school, that 'beliefs-thoughts' can create important dynamic effects over the economy. He also has a book on this subject. I will continue with this subject in our fourth traditional Sunday's commentary.

This commentary was published in Radikal daily on 17.01.2010