23 Things They Don't Tell You About Capitalism

Simon’s favourite example of how we need some rules in order to cope with our bounded rationality was chess. With only thirty-two pieces and sixty-four squares, chess may seem to be a relatively simple affair, but in fact involves a huge amount of calculation. If you were one of those ‘hyper-rational’ beings (as Simon calls them) that populate standard economics textbooks, you would, of course, figure out all the possible moves and calculate their likelihoods before you make a move. But, Simon points out, there being around 10120 (yes, that is 120 zeroes) possibilities in an average game of chess, this ‘rational’ approach requires mental capacity that no human being possesses. Indeed, studying chess masters, Simon realized that they use rules of thumb (heuristics) to focus on a small number of possible moves, in order to reduce the number of scenarios that need to be analysed, even though the excluded moves may have brought better results.

If chess is this complicated, you can imagine how complicated things are in our economy, which involves billions of people and millions of products. Therefore, in the same way in which individuals create routines in their daily lives or chess games, companies operate with ‘productive routines’, which simplify their options and search paths. They build certain decision-making structures, formal rules and conventions that automatically restrict the range of possible avenues that they explore, even when the avenues thus excluded outright may have been more profitable. But they still do it because otherwise they may drown in a sea of information and never make a decision. Similarly, societies create informal rules that deliberately restrict people’s freedom of choice so that they don’t have to make fresh choices constantly. So, they develop a convention for queuing so that people do not have to, for example, constantly calculate and recalculate their positions at a crowded bus stop in order to ensure that they get on the next bus.

The government need not know better

So far so good, you may think, but what does Simon’s theory of bounded rationality really have to say about regulation?

Free-market economists have argued against government regulation on the (apparently reasonable) ground that the government does not know better than those whose actions are regulated by it. By definition, the government cannot know someone’s situation as well as the individual or firm concerned. Given this, they argue, it is impossible that government officials can improve upon the decisions made by the economic agents.

However, Simon’s theory shows that many regulations work notbecause the government necessarily knows better than the regulated (although it may sometimes do – see Thing 12) but because they limit the complexity of the activities, which enables the regulated to make better decisions. The 2008 world financial crisis illustrates this point very nicely.

In the run-up to the crisis, our ability to make good decisions was simply overwhelmed because things were allowed to evolve in too complex a manner through financial innovation. So many complex financial instruments were created that even financial experts themselves did not fully understand them, unless they specialized in them – and sometimes not even then (see Thing 22). The top decision-makers of the financial firms certainly did not grasp much of what their businesses were doing. Nor could the regulatory authorities fully figure out what was going on. As discussed above, now we are seeing a flood of confessions – some voluntary, others forced – from the key decision-makers.

If we are going to avoid similar financial crises in the future, we need to restrict severely freedom of action in the financial market. Financial instruments need to be banned unless we fully understand their workings and their effects on the rest of the financial sector and, moreover, the rest of the economy. This will mean banning many of the complex financial derivatives whose workings and impacts have been shown to be beyond the comprehension of even the supposed experts.

You may think I am too extreme. However, this is what we do all the time with other products – drugs, cars, electrical products, and many others. When a company invents a new drug, for example, it cannot be sold immediately. The effects of a drug, and the human body’s reaction to it, are complex. So the drug needs to be tested rigorously before we can be sure that it has enough beneficial effects that clearly overwhelm the side-effects and allow it to be sold. There is nothing exceptional about proposing to ascertain the safety of financial products before they can be sold.