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Alasdair White has long argued that some of the ‘economic truths’ of the last 50 years are built on shifting sands and unstable foundations. In this second blog on the subject, he looks at the underlying fallacy of most economic theory – the subject of full knowledge and rationality.

The basic theory of efficient markets and certainly that of microeconomics (the school of economics in which people are involved as individuals) is based on the idea that economic actors (or economic agents – the various people involved) have full knowledge of all the factors that influence the decisions being made AND that they then act in a rational manner based on that knowledge. The truth is somewhat different: the actors involved very often do not have access to the knowledge they require, or they do not have the experience and ability to interpret that knowledge, or they simply do not know that they do not have all the information and knowledge they need.

And then there is the question of rationality!

Rationality – the quality of being rational or having the faculty of reasoning – presupposes an evidence-based process of decision-making as against, I suppose, decision-making based on emotions and superstitions. Rationality first appeared as a concept under that name in the late 1500s, at a time when philosophers were seeking to establish that what differentiates ‘man’ from all other animals was the ability to take decisions based on consideration of abstract information. This is also the time when we see the emergence of the type of thinking that less than a hundred years later gave rise to Newtonian physics and scientific rationalism.

In philosophy, a rational decision is one that is not just reasoned, but is also optimal for achieving a goal or solving a problem. This makes it conceptually normative (how things ought to be – i.e. a value judgment – as against how things are) and assumes (a) that rational people should (or will) derive conclusions in a consistent way given the information at their disposal, (b) they really do understand the goal or problem, and (c) they are able to judge whether a method is actually optimal rather than something they want to believe is optimal. A ‘rational decision’, therefore, demonstrates conformity of the decision-maker’s beliefs with their reasons to believe, or of their actions with what they believe are their reasons for action.

In the strange world of the economist, rationality and rational decision-making have given rise to ‘rational choice theory’ – also known as choice theory or rational action theory – which is a framework for understanding and modelling social and economic behaviour and is the main theoretical paradigm in the currently dominant school of microeconomics. Rationality, here equated with “wanting more rather than less of a good”, (i.e. something that can be bought and sold) is widely used as an assumption of the behaviour of individuals in microeconomic models and appears in almost all economics textbook treatments of human decision-making.

Microeconomists seek to examine how the decisions of individuals are affected by the supply and demand for goods and how this determines the prices of those goods. In other words, they seek to examine ‘markets’ as a mechanism for establishing prices and assume that such markets are perfectly competitive. Indeed, much of their theory is based on trying to justify the fluctuation in prices, usually why prices always seem to rise even when there is no ‘actual’ shortage of the goods but merely a perceived risk that a shortage may occur, which most behavioural psychologists would explain is caused by an emotive response called ‘greed’!

Behaviourists and many others think that any kind of rationality along the lines of ‘rational choice theory’ is a useless concept for understanding human behaviour and they are dismissive (rightly so, in my opinion) of the economist’s term homo economicus: the imaginary man being assumed in economic models as a rational and narrowly self-interested actor who has the ability to make judgments toward their subjectively defined ends, who is logically consistent but amoral, and attempts to maximize utility as a consumer and economic profit as a producer. All of which is another way of saying that homo economicus is assumed to be profoundly selfish, would never act altruistically, and is greedy, which is in stark contrast with the concept of homo reciprocans who is assumed to be primarily motivated by the desire to be cooperative and to improve their environment.

If you have studied the work of Geert Hofstede on cultures, one reasonable conclusion would be that those who come from a highly individualistic culture (for example: the classic “Anglo-Saxon” cultures of the USA or the UK,) are likely to fit the concept of homo economicus while those who don’t (for example, the Asian cultures) are likely to fit the concept of homo reciprocans. It will also come as no surprise to find that the leading microeconomic theorists are from theUSA and theUK.

While the concept of homo economicus can be used to justify and even encourage greed, selfishness, and short-term horizons, it does nothing to address long-term enlightened self-interest. Perhaps inevitably, it leads directly to the sort of economic activity – especially trading activity – that led directly to the financial crisis of the last five years in which ‘free-market economics’, (a sub-set of microeconomics in which light regulation is thought to encourage perfectly competitive markets) has proven to be unsustainable and that homo economicus cannot function without enforceable rules to mitigate or control behavioural and often emotional responses. Indeed, we have much to learn from this failure – not the least that slavish adherence to such a flawed theory leads to economic collapse and demonstrates that homo economicus is either wilfully self-destructive or simply irrational.

Hard as it may be for many of the commercial and economic ‘masters of the universe’ to accept, they are not acting in the best interests of anyone and the result has been economic losses of staggering proportions as the world struggles to avoid recession, depression and deflation. An example at a micro level would be to consider the performance of investment ‘professionals’ and their failure in their fiduciary responsibility towards those who ‘trusted’ them with their money: one well-known and ‘respected’ British life-assurance company managed to achieve just 18% net growth in 25 years (or a staggering minus 50% growth in inflation-adjusted terms), and then there are the thousands who have had their pensions wiped out and who will now have to work long past their planned retirement age.

I suppose the truth is that economists, especially microeconomists, have been so persuasive that over time the politicians (who should have regulated) and the public (who should have known better) have become enthralled ‘to some long dead economist’ (to quote Keynes) and the dismal science has been allowed to rule our lives as we abandoned rational thought and assumed that these so-called ‘experts’ knew what they were talking about.

How much better it would have been if the so-called economic ‘gurus’ had not suffered from an excess of hubris in which they have lost contact with reality and have overestimated their own competence. And how much better it would be for all of us if the news media did not encourage that hubris by wheeling out ‘an economist’ every time they reported on commercial or financial matters.

The reality is that ‘bounded rationality’ is a concept closer to the truth. Bounded rationality is the idea that, in decision-making, the rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision. Economists in particular and the public in general should learn that they almost never have access to all the information they need; that their cognitive abilities are limited by their culture, their upbringing, their education and their willingness to think outside the false limitations set by others; and that we simply don’t have the time to ponder all the variables. Those who can accept ‘bounded rationality’, and work within it successfully and sustainably, are the people we should be listening to.

That the hubristic are often young and generally dismissive of older and more experienced voices reminds me of the Zen expression: “I am no longer young enough to know all the answers”. On the other hand, those who are older and should be wiser have forgotten that knowledge is neither finite nor fixed, that there are infinite versions of the truth, and that a wise man can entertain two conflicting ideas in his mind at the same time while being willing to discard concepts when demonstrably unsustainable.

Alasdair White has been a business school professor and management development consultant for over 20 years. He has written five best-selling management books and a thriller. He is currently writing a second thriller as well as preparing for the new academic year.