23 Things They Don't Tell You About Capitalism

When the Nobel Prize-winners in financial economics, top bankers, high-flying fund managers, prestigious colleges and the smartest celebrities have shown that they do not understand what they are doing, how can we accept economic theories that work only because they assume that people are fully rational? The upshot is that we are simply not smart enough to leave the market alone.

But where do we go from there? Is it possible to think about regulating the market when we are not even smart enough to leave it alone? The answer is yes. Actually it is more than that. Very often, we need regulation exactly because we are not smart enough. Let me show why.

The last Renaissance Man

Herbert Simon, the winner of the 1978 Nobel Prize in economics, was arguably the last Renaissance Man on earth. He started out as a political scientist and moved on to the study of public administration, writing the classic book in the field, Administrative Behaviour. Throwing in a couple of papers in physics along the way, he moved into the study of organizational behaviour, business administration, economics, cognitive psychology and artificial intelligence (AI). If anyone understood how people think and organize themselves, it was Simon.

Simon argued that our rationality is ‘bounded’. He did not believe that we are entirely irrational, although he himself and many other economists of the behaviouralist school (as well as many cognitive psychologists) have convincingly documented how much of our behaviour is irrational.[2] According to Simon, we try to be rational, but our ability to be so is severely limited. The world is too complex, Simon argued, for our limited intelligence to understand fully. This means that very often the main problem we face in making a good decision is not the lack of information but our limited capability to process that information – a point nicely illustrated by the fact that the celebrated advent of the internet age does not seem to have improved the quality of our decisions, judging by the mess we are in today.

To put it another way, the world is full of uncertainty. Uncertainty here is not just not knowing exactly what is going to happen in the future. For certain things, we can reasonably calculate the probability of each possible contingency, even though we cannot predict the exact outcome – economists call this ‘risk’. Indeed, our ability to calculate the risk involved in many aspects of human life – the likelihoods of death, disease, fire, injury, crop failure, and so on – is the very foundation of the insurance industry. However, for many other aspects of our life, we do not even know all the possible contingencies, not to speak of their respective likelihoods, as emphasized, among others, by the insightful American economist Frank Knight and the great British economist John Maynard Keynes in the early twentieth century. Knight and Keynes argued that the kind of rational behaviour that forms the foundation of much of modern economics is impossible under this kind of uncertainty.

The best explanation of the concept of uncertainty – or the complexity of the world, to put it another way – was given by, perhaps surprisingly, Donald Rumsfeld, the Defense Secretary in the first government of George W. Bush. In a press briefing regarding the situation in Afghanistan in 2002, Rumsfeld opined: ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ I don’t think those at the Plain English Campaign that awarded the 2003 Foot in Mouth award to the statement quite understood the significance of this statement for our understanding of human rationality.

So what do we do, when the world is so complex and our ability to understand it so limited? Simon’s answer was that we deliberately restrict our freedom of choice in order to reduce the range and the complexity of the problems that we have to deal with.

This sounds esoteric, but when you think about it, this is exactly what we do all the time. Most of us create routines in our life so that we don’t have to make too many decisions too often. The optimal amount of sleep and the optimal breakfast menu differ every day, depending on our physical conditions and the tasks ahead. Yet most of us go to bed at the same time, wake up at the same time and eat similar things for breakfast, at least during the weekdays.