A sideways look at economics

I’ve been looking forward to my first TFiF. As a former Fathom client and now employee, I’ve always found this blog refreshing and a window into the writer’s soul. An economist’s soul. Some might say a dark place full of uncomfortable, narcissistic and unnecessarily complicated truths. Those people wouldn’t be wrong and, will hopefully, be thoroughly pleased by what’s in store.

In anticipation of my blog debut, I’ve been busy filling out my very own hit list of topics to snipe at over the coming months. My first shot is aimed at people who fail to understand the mystical beauty of assumptions in economics – how simple, but broadly true, generalisations can yield powerful conclusions in a triumph of human ingenuity. You know who I’m talking about, right? The snarky student at the back of the lecture hall trying to catch out the professor; the slimy colleague trying to shoot down an inconvenient truth; the question from the shiny-suited member of the audience at the end of a long conference. They all would say some variation of: “yes, but is this assumption realistic?” To this day, I’ve not found any anger management technique able to sooth the raging fit that these words arouse in my inner being.

Please, indulge me in this hyperbolic rant. I would posit that economics makes assumptions precisely because there are people questioning these without offering any constructive alternatives. These people should be assumed away as outliers offering nothing to society but the sound of their own voice. Ultimately, they’re not being rational by sacrificing powerful conclusions on the altar of ill-defined alternatives. Of course, rationality isn’t an economic assumption as some of these people might be implying (though I wouldn’t want to assume what they might be implying by ‘realistic’). Rationality is a hard-wired evolutionary trait that sits at the very root of the success of human race. Thanks to the Darwin Awards, we even, rightly, celebrate people whose irrationality leads them to wipe their genetic pool from this planet. Fast forward nth-tillion years and this dynamic alone should make irrationality extinct. Economic assumptions are just getting us there faster.

To me, the best assumptions in economics create a sense of mystical awe and respect on par with the first time I entered St Peter’s basilica as a child, or stepped onto Tiananmen Square ten years ago on a rugby tour (a story for another time), or walked around the ruins of Pompei. The dopamine high I get is so strong that the thought that some people might not share this scares me. What are they going to say next: pizza isn’t good? Just like pizza and other classic dishes from my mum, economic assumptions create powerful and permanent Pavlovian memories that go beyond a single sensory experience.

The best example is this great paper from 1991 that I read in the Economics of Social Interactions class during my Economics Masters course many moons ago. No, the class was not held in a tipi in the Mexican desert by a Navajo shaman. But nevertheless, the whole experience turned out to be a fantastic trip. The authors are from a strand of economic literature that actually challenges standard economic assumptions by adding valuable lessons from other social sciences such as sociology or psychology. The world would be a better and more rational place if every reasonable economic assumption was contested by people of their calibre.

In this paper they present a model where people care about their relative position in society as well as their level of wealth. Incorporating this behaviour relaxes the standard consumption-saving assumption that agents’ incentives to save depend only on increased future consumption. Importantly, they find that there are multiple equilibria depending on how society allocates status. If status is linked to wealth, individuals have an incentive to save more, particularly those with higher than average income levels. This will lead, over time, to less equal societies relative to a model not embedding social norms. Also, the incentive to save to acquire status disappears in societies that are already very unequal, essentially killing the prospects of social mobility. The powerful bottom line is that the introduction of competition for social status could explain a far richer set of economic growth outcomes beyond the classic one.

Yes, but are their assumptions realistic?

As always, in order to relax an assumption, you make some others. The authors arrive at these powerful conclusions by assuming that individuals care about their social status and that status is partly inherited. The other key assumptions revolve around the matching dynamics of individuals. Men and women will match to produce two offspring of each sex. A couple makes standard economic decisions on what to consume and invest jointly. They both also care about the status of their offspring. This is where the equalities in the sexes end, and some readers might want to look away now.

Only male offspring inherit status from the parents and they seek to match with the most attractive partner. To be fair, the authors don’t specify this and, in the paper, women are endowed with a more prosaic “non-traded, non-storable good”. Men can make only one offer to a woman to match. The woman will accept the offer promising the highest current consumption. When status is determined by wealth, a male will choose whether to consume more to attract a better female partner or save and bequeath a better status to his offspring. That’s basically it. All the different societal equilibria stem from how status is selected and by these slightly old-fashioned social norms that are, unfortunately, still common in many societies around the world. Fight old assumptions with newer assumptions and even more powerful conclusions. This paper doesn’t challenge the assumption that agents are utility maximising, although it does challenge the assumption that utility is derived solely from consumption, which most economic models assume. The authors haven’t reinvented the wheel: they’ve simply found some rationality amid all the seemingly irrational behaviour.

If you’re still not convinced about how amazing this paper is, I would suggest a more attentive read, as a short blog can hardly do it full justice. I would particularly encourage the more sceptical to turn to the bottom of page 25 first: “But think for a moment about an already very rich agent like Donald Trump. Why does he continue to work long days, endure substantial amounts of stress and take enormous risks? Surely it can’t be because he is savouring the prospect of going to the grocery store with a looser budget constraint next year. […] We propose that people like Donald Trump continue to care about increasing their net worth because their utility depends not only on the absolute level of their wealth, but also on their wealth relative to other very rich people”. This was written in 1991. I’ll leave the rant about economists and their forecasts for another day.