How We Misunderstand Economics

Why is economics so difficult? We argue that widespread economic misconception derives from an acute mismatch between the complexities of economics and the constraints of human cognition. In this chapter we flesh out the former side of the mismatch: the aggregate, dynamic, multifaceted, and impersonal nature of economic explanation.

Economic explanations rely on aggregate measures which abstract away and across individuals and their transactions. Most laypeople focus on individuals. Economic accounts integrate direct, indirect, and feedback effects into a coherent system of causal links, explaining how effects evolve over time from diffuse sources. Laypeople give excessive weight to direct effects, locating causality at a focal place and time.

Economics accounts for aggregate measures by the dynamic interplay between them, and often invoke equilibrium states where ‎economic ‘forces’ gradually balance each other. This kind of thinking is foreign to everyday thinking. Finally, economic explanations are impersonal and amoral. In economic models effects flow irrespective of the intentions or morality of the individual agents and transactions involved. Laypeople mostly explain economic events in terms of the beliefs, desires, intentions, and goals of individuals and groups involved in them.

Examples are given throughout.

We have argued that economic misconception derives from a mismatch between the complexities of economics and the constraints of human cognition. This chapter focuses on the latter.

Lay explanations of economics suffer two crippling flaws: they have a short ‘range’, and a narrow scope. When trying to comprehend an economic issue, most people entertain only simple and direct causes, neglecting indirect effects and the links between them. ‘Narrow scope’ owes to the nature of retrieval from long-term memory (LTM). People do not trawl LTM for pertinent information, but rely on the first things that come to mind. In addition, people do not trace through the causal chains leading to and from the issues at hand. This ‘short range’ results from the exiguity of working memory (WM).

The complexity of reasoning is bounded by the number of items and interrelationships kept active in WM. Its limited capacity means that complex ideas are hard to entertain, and long chains of reasoning difficult to follow. For this reason, people do not appreciate opportunity costs (failing to generate and evaluate alternatives) and ignore equilibria (failing to consider interdependence), among several additional flaws we discuss in this chapter.

Unemployment and inflation are the most important macro-economic variables that non-economists care about; they affect people directly and significantly. And since voters hold their government accountable for economic performance, they are also of great consequence for politicians.

In this chapter, we review the psychology of inflation and unemployment. We illustrate how the complexities of the issues, coupled with the constraints of working and long-term memory, conspire to shape people’s (mis)understanding in these domains. With regards to unemployment, we show how people come up with only the most obvious and direct solutions (‘make work’ policies), and review studies showing the remarkable lack of breadth and depth in their mental models of how it is produced. Perceptions and expectations of inflation are especially important as they feed into the inflation-generating process itself. Inflation is considered by people to be a prime symptom of economic crisis, though persistent inflation tends to become the normal state in an economy. We show how people’s mental models of inflation narrowly reflect their own particular economic needs and circumstances: scarcely any factors come up in people’s mental maps which do not immediately impinge on their lives.

In this chapter, we uncover the logic that underlies people’s evaluations of how macroeconomic variable interact. People typically think in terms of pairwise links, and not beyond. We present a study in which people were presented with pairs of variables (e.g. GNP, growth rate, wages, etc.) and asked to judge how a change in one would affect the other. Multidimensional scaling found that the variables neatly clustered into two groups: those perceived to be good (e.g. national credit rating, corporate profits), and those perceived to be bad (e.g. tax rate, inflation). Further, it was found that when people made pairwise judgments, they relied on a simple yet powerful trick: ‘good’ things enhance other ‘good’ things and suppressed ‘bad’ ones, while ‘bad’ things enhanced other ‘bad’ and suppresses ‘good’ ones. This trick, dubbed the Good-Begets-Good heuristic, explains how people manage to readily answer how any two variables interact, without a clue as to the mechanism responsible for the putative influence.

The GBG heuristic means that on a large scale, people generate waves of optimism and pessimism, which go on to affect aggregate demand.

In previous chapters we highlighted the challenges inherent in lay economic understanding. How then do people come to hold the opinions that they do? This chapter explores one avenue: reasoning by metaphor. Metaphors allow us to understand novel phenomena using familiar terms. At the cognitive level, this manifests in the process of structure mapping, which lies at the basis of analogical reasoning.

Media and political discourse are suffused with economic metaphors, and these metaphors trickle down to the public. We review the discourse analysis literature and point to the most popular economic metaphors. We show how metaphors, though useful, carry a heavy cost; they highlight and hide, lead but mislead.

By drawing on real-world examples, we show how metaphors infiltrate our mental representations and skew our understanding of important economic concepts. We explore the power of metaphor to activate our most basic modes of understanding the world – our ‘framework theories’ of biology, psychology, and physics – bringing them to bear on economic actors and processes. In particular, intuitive psychology introduces highly significant biases to economic understanding, including conspiracist ideation and over-attribution of economic events to the intentions and actions of individuals.

Capitalism is notoriously controversial. In this chapter we trace the moral-psychological roots of the capitalism debate. We identify two central factors shaping lay views: first, attitudes to the profit motive, and second, differing conceptions of fairness. Anti-capitalist beliefs are rooted in a social view of the world as a place of cooperation and harmony, where people are naturally compassionate. Pro-capitalist beliefs stem from a view of the world as a place of competition over resources, where people are naturally self-interested.

Next, we show how pro- and anti-capitalists favor distinct notions of fairness: proportionality (people get what they deserve) and egalitarianism. The anti-capitalist inclination for egalitarianism stems from their belief that inputs (e.g. effort) and economic outcomes are only loosely connected. The pro-capitalist defense of proportionality is predicated on the belief that, in the real world, inputs and outcomes are tightly connected.

We then point to political ideology (liberal versus conservative) as the source of people’s beliefs about the strength of connection between inputs and outcomes. People adopt their beliefs wholesale from their political ideology, circumventing the cognitively ‘expensive’ task of deliberating about each and every economic question.

Historically, money went from being commodity-based and possessed of intrinsic value to being conventional, its value grounded in the trust of the community, and orchestrated by a central authority. Most people don’t know where money comes from, nor how it is distinguished from actual wealth.

They treat money as if it were a commodity valuable itself (rather than having a fiat value). Money consistently evokes emotions and affects behavior in ways that suggest it acts on the human mind and physiology as a kind of drug. It is not only treated as a tool for future acquisition, but as gratifying by itself.

For this reason, we suggest, people violate the notion of fungibility: they are more willing to spend money that feels less ‘real’ such as credit cards and gambling chips, though it is not.  That is also why people prefer to get dividends rather than accrue capital gains. We suggest that money is perceived along a continuum, from ‘real’ cash to bank credit, to ‘virtual’ money embedded in financial instruments.

Over the past decade, the extent of the ignorance of financial basics has become apparent. Untrained people have difficulties understanding even basic financial concepts such as the functioning of an interest rate or the principle of risk diversification. And people pay the price: low levels of financial literacy are associated with poorer economic outcomes.

The natural response may be to impart financial literacy to the public, but this avenue shows little promise. Extensive reviews of the research find that financial education has little to no effect on knowledge or lasting behavioral change. What matters most for financial behavior are stable personality characteristics such as locus of control, numeracy, conscientiousness, and the tendency to procrastinate.

Responsible regulators must take stock of the limits that human nature imposes upon rationality, whether from the emotional or the cognitive side. In practice, this means a careful mix of regulating the markets and encouraging, or requiring, the use of impartial advisers. Further, there is the important matter of educating citizens to enable their informed participation in debates on essential economic and social choices. That educational challenge is huge, and will require a sustained effort.

Misunderstanding economics is a natural state of affairs in view of the mismatch between innate cognitive tendencies and the analyses and concepts developed in economic science. Lay thinking suffers two crippling flaws: a ‘short range’ and a ‘narrow scope’, shortcomings stemming from cognitive constraints on working- and long-term memory. As a result, laypeople focus on direct causes, ignoring indirect, aggregate, and feedback effects.

When the proper explanation eludes them, laypeople rely on a range of means to navigate abstruse economic topics, including intention attribution, reasoning by metaphor, reliance on ideologically-prepackaged ideas, overextending personality traits, and good-bad dichotomies. People’s beliefs are important as they feed into the economic process, both through their behavior and via the political process, affecting public policy.

We suggest a two-tier model for economic understanding. Some knowledge cannot be shared with the public, not because it is secret but because it is inaccessible. Other parts are potentially accessible, and every effort should be made to convey them. The present work did its best to characterize where the boundary between the two lies.  We suggest several ways in which public policy should be responsive to these facts of life.