How We Misunderstand Economics

And Why It Matters

About The Book

This is the first book to explain why people misunderstand economics. From the cognitive shortcuts we use to make sense of complex information, to the metaphors we rely on and their effect on our thinking, this important book lays bare not only the psychological traits that distort our ability to understand such a vital topic, but also what this means for progressive policy makers, and civil society more widely.

Accessibly written, the book explores the mismatch between the complexities of economics and the constraints of human cognition that lie at the root of our misconceptions. The authors document and explain the gamut of cognitive strategies laypeople employ as they grapple with such complex topics as inflation, unemployment, economic crises, finance, and money in the modern economy. It examines sources of misconceptions, from the intentionality fallacy, whereby economic phenomena are assumed to have been caused deliberately rather than to have come about by an interplay of many agents and causal factors, to the role of ideology in framing economic thinking.

Exposing the underlying biases and assumptions that undermine financial and economic literacy, and concluding with recommendations for how policies and ideas should be framed to enable a clearer understanding, this will be essential reading not only for students and researchers across psychology and economics, but also anyone who wants to understand the roots of the appeal of populist economic policies.

Chapter Abstracts

Chapter 1 – Introduction
Most people’s understanding of economics is remarkably flawed. We have a tough time comprehending complex systems in any domain, and the economy is no exception.

Lay people lack an elementary grasp on basic economic concepts, and are unaware of the extent of their ignorance. This predicament results from an acute mismatch between the complexities of economics and the constraints of human cognition. Attempts to ‘bridge the gap’ (by communication and education) have failed. And yet, people are expected to have economic views, and they do.

This is important because what people think affects how they act, and how they act, collectively, affects the economy. Moreover, people’s beliefs figure prominently in the democratic process, constraining which policies can be implemented and at what political cost.

In this chapter, we delineate the field we will explore in the book: economic understanding, or how people think in the economic domain. We ask: what are the features of economics that make it so difficult? What are the cognitive constraints which imperil understanding? How do people come to grips with the workings of the economy? And what might this all mean for policy makers?

Chapter 2 – Why is economics so hard?
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.

Chapter 3 – Cognitive Hurdles
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.

Chapter 4 – Unemployment and Inflation
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.

Chapter 5 – The Good-Begets-Good Heuristic

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.

Chapter 6 – What is the economy like?
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.

Chapter 7 – Capitalism
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.

Chapter 8 – Money and Wealth
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.

Chapter 9 – Financial Literacy
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.

Chapter 10 – Implications for public policy
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.

About The Authors

Prof. David Leiser

David Leiser is a renowned specialist in Economic Psychology. He is past-president of the Economic Psychology division of the International Association of Applied Psychology (IAAP), a former president of the International Association for Research in Economic Psychology (IAREP), founder and founder and past Director of the Inter — Faculty Center for Decision Making and Economic Psychology (DMEP) at Ben Gurion University, Israel, where he is Full Professor of Social and Economic Psychology.

Prof. Leiser holds a BSc in Mathematics from the Hebrew University in Jerusalem, a MS in Adult Education from the University of Illinois at Urbana — Champaign, and a PhD in Psychology from the University of Geneva, Switzerland, where he served as Research Assistant to Jean Piaget. He held visiting positions at the University of Chicago, MIT, Yale, Harvard, and Paris II (Panthéon — Assas) and Paris V (René Descartes).

He studies human understanding, with an emphasis on investigating how non-economists understand economic issues. Such studies aim to inform efforts to improve financial literacy and to enhance communication with the public by the authorities and financial institutions.

Yhonatan Shemesh, MA

Yhonatan Shemesh holds a BA and MA in cognitive science from Ben-Gurion University of the Negev. His research focuses on the ways the human evolutionary cognitive endowment affects how people think and act in the modern world.

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Praise & Reviews

“This book is a must read for economists playing an active role in the public debate. It explains why so many relevant economic messages are lost in translation

Widespread misunderstandings arise, according to Leiser and Shemesh, because laypeople are socially encouraged to have a view on complex economic issues, and are over-confident in their capacity to address these issues based on a combination of anecdotes, naive theories, and misleading metaphors.

Identifying the cognitive traits that make people perceptions diverge from the way of thinking of economists is a first indispensable step towards finding ways to bridge the communication gap between economists and the general public"

Tito Boeri, Economics, Bocconi University, Italy

President, INPS, Italy Social Security and Pension Authority

 

"For decades economists have tidily cultivated their own scientific gardens and forgotten that complex socio-economic issues may be effectively tackled with better knowledge of human beings on top of sophisticated equations. A plea for a multidisciplinary approach, this book is a much-needed attempt to foster dialogue and bridge the cognitive segmentation of social sciences."

Elsa Fornero, Professor of Economics, Turin, Italy

Former Minister of Labor and Social Affairs (Monti Government)

 

“This engagingly written book takes us above and beyond traditional judgment and decision-making studies and the heuristics and biases of behavioral economics to explore how people develop explanatory models and concepts in the domain of economics.

It contains many fascinating insights into the challenges laypeople have in understanding seemingly simple but deeply complex phenomena and economic entities (e.g. money), as well as offering a bold new direction for research into a topic where greater lay understanding has enormous social policy consequences.”

– Frank Keil, Psychology, Yale University, USA

“In recent years, many economists have used psychology to understand the economy better. In their enlightening new book, Leiser and Shemesh use psychology to explain why most people understand economics so poorly.

Economics insights often butt against deep-rooted ways of thinking about the world.  And even when the lessons of economics are intuitive, economists’ rhetoric is not.

How We Misunderstand Economics and Why It Matters is a great book for anyone who wants to understand the economy – or explain it to others.”

– Bryan Caplan, Economics, George Mason University, USA

“Economic ignorance is still quite often considered as a peccadillo.
This mistaken estimate is not only regrettable but has fatal consequences for individual and societal wellbeing – as attested by a series of recent disastrous decisions at the personal, national and global level.

The book by Leiser and Shemesh is an excellent example of how profound, rigorous and multidisciplinary research can shed light into the black box of everyday economic reasoning.
It stimulates fresh and inspiring ideas on how we can tackle the problem of economic illiteracy, and thus ought to become compulsory reading for all those concerned with the education of
economically well-informed and mature citizens.”

– Carmela Aprea, Business and Economics Education

University of Mannheim, Germany

An easily accessible and inspiring starting point especially for economists who want to learn what psychology has to offer

A better understanding of how laypeople perceive ... the economic environment in which they act helps us to develop more adequate models – both in micro- and macroeconomics.
These models can help us ... design better policies.
[The book explains] why voters often oppose policies that economists consider helpful and/or support policies not considered helpful.”

Ivo Bischoff, Economics, Kassel University, Germany

Book review for the Journal of Behavioral and Experimental Economics

 

“Given the broad implications of faulty reasoning in the economic sphere for individuals
as well as for society, this book is a must read for laypeople, policy makers, government officials as well as students.

(...) This is a scholarly work with over 500 references, well-grounded in academic theory and empirical work. At the same time, it is a highly enjoyable read, (...)  sprinkled with vignettes, scenarios, narratives, and cartoons."

– Esther Greenglass, York University

Book Review for the Journal of Economic Psychology

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