Sunday 23 October 2016

Economists must learn that people - and politicians - don't always act rationally

Jim Power

Published 04/06/2015 | 02:30

The economics profession globally has attracted a lot of negative press in recent times and it has caused the profession to engage in a severe soul-searching exercise. I am not sure what is emerging from this exercise other than the opening up of a massive chasm in the field of macro-economics, with many of the elite protagonists now at each other's throats, particularly in the realms of academia.

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If anybody is curious, it is possible to follow some of the vitriolic exchange of views online or on the various blogs. It is faintly amusing.

The serious issue though is that most, if not all, of the economic models that have been utilised in recent years, many of which are based on very complex mathematical algorithms, failed to diagnose the serious imbalances that were building up in the global economy in the early years of the noughties, mainly on the back of the deregulation of the global financial services industry dating from the Reagan years.

Ultimately they totally failed to predict the eventual collapse of the whole system.

Lessons will have to be learned by those who drive economic policy theory and ultimately those who implement it. The key lesson is that economic history will ultimately tell us a lot more than any sophisticated mathematical model.

A second lesson is that much more attention should be paid to behavioural economics. It is clear that sophisticated models struggle to understand human behaviour, but unless one has a clear understanding of human behaviour, and particularly the behaviour of politicians, who after all are humans as well, one will fail to have any understanding of what the future might be like.

A third lesson is that the interaction of economics and politics can be very dangerous and damaging.

The reality is that economics is a social and not a physical science. Economic outcomes are generally driven and shaped by human behaviour, and unfortunately human behaviour is rarely possible to predict with any degree of certainty.

Much economic modelling is based on the premise that people act rationally, but I think it is time that we recognise that rational human behaviour is not that common. I have certainly struggled over the years to accommodate the actions of politicians in my economic forecasts, but of course politicians are really only responding to the wishes of the people who elect them.

Here in Ireland over the past week we have certainly seen a good example of the clash between primacy political and economic logic.

The Government has decided to sell its remaining stake in Aer Lingus. Nothing wrong with that! A small airline such as Aer Lingus would struggle to survive on its own in an increasingly globalised airline industry where scale seems to be the key survival technique. Aer Lingus is performing well at the moment, but in the event of a future shock, there would have to be a huge question mark over its ability to deal with it, particularly as it would not be possible for the State to bail it out again as it did so often in the past.

The big decision relating to Aer Lingus was of course taken a few years back when the government of the day sold 75pc of the airline. The good thing now is that the State has got commitments from the prospective new owners that Aer Lingus would have struggled to deliver if left in its current shape. The suggestion that Ireland will now lose its national airline is utter rubbish. That status was lost when the initial stake was sold. In any event, Ryanair has assumed that status over recent years and has arguably done a lot more for the national interest than Aer Lingus ever did. After all Ryanair made air travel accessible and affordable for the masses and has made a huge contribution to tourism. One could certainly argue that Ireland is now on the brink of having the best of both worlds, with two airlines of scale serving the country.

People will have different views on the imminent sale of the airline, but it looks a done deal. Over €350m will be received by the Exchequer, which could make a significant contribution to providing economically and socially desirable goods such as more primary healthcare or enhanced education resources.

Instead of delivering such goods, the Government will effectively use these resources and a further €200m more besides to give back to public sector workers the money taken from them under emergency legislation when the economic crisis erupted. This is an example of where politics and economics clash. From an economics perspective the notion of reversing emergency measures when the emergency has not yet dissipated does not look particularly prudent or sensible.

This year the state will spend approximately €5bn more in running the country than it will collect in revenues. Public sector pay increases will add directly to the cost of running the country, although most of the extra earning will find its way back into the economy in expenditure and tax revenues. Nobody could argue that it is not important to put money back into the pockets of workers, but why pick out public sector workers for special attention? The reality is that private sector and public sector workers have both suffered severe pain since 2008, and in fact thousands of private sector workers lost their jobs, while the public sector saw no forced redundancies.

Self-employed people will also find this latest public sector agreement difficult to stomach, given how the tax system is biased so heavily against them and also given how challenging the environment still is for the self-employed.

Rather than increasing public sector pay, the Government would be much better advised to put money back into workers' pockets through the tax system, starting with a dismantling of the punitive USC. This would benefit all workers and not just the privileged few, many of whom have pension arrangements that the rest of us could only dream about.

However this sort of economic logic, which many public sector workers would obviously disagree with, does not stand up to political scrutiny. The Labour Party is clearly concerned about its political survival and with less than a year to go to an election, will do anything it takes to buy votes. Potentially getting over 300,000 workers on side makes political sense, but is it in the best overall interests of the national good? I think not!

The Irish economy is clearly in recovery mode, but there are still many challenges to overcome, not least the very unbalanced geographical nature of the recovery. The fear now is that auction politics will hold sway over economic prudence over the coming months and the risk is that short-term politically motivated decisions will do longer-term economic damage.

There is some considerable precedent for this, but it is something that economic forecasters will never be able to handle. It is great to have something to blame!

Jim Power is an economist and commentator and is editor of Friends First's regular 'Economic Outlook'

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