The Key To Understanding The Current Inflation Predicament And The Global Financial Crisis

The inflation which central banks around the world are attempting to control reflects irrational choices made by policy makers. In April 2020, I warned about the risk of reigniting inflation when I wrote: “The challenge for policy makers is to aim for a stimulus package that is neither too weak and allows for deflation, nor too strong and produces inflation… The attempt to achieve both low unemployment and a high real wage will lead to ever increasing inflation, as workers set nominal wages in anticipation of higher future inflation.”

In my opinion, it was irrational for policy makers’ attempt to achieve low unemployment in a pandemic-constrained global economy, using the degree of stimulus they did. In my opinion, it was irrational to treat the economic situation which unfolded during the pandemic as being similar to the economic situation which unfolded after the global financial crisis (when economic stimulus measures were too weak).

Non-rational behavior is what behavioral economists study, and they call out irrationality when they see it. In contrast, many non-behavioral economists are reluctant to call out irrationality, and instead try to explain real world events, to the extent possible, as the outcome of rational behavior. I would call this tendency “excessive rationality-assumption bias.”

Despite the presence of excessive rationality-assumption bias in their works, the 2022 Nobel prize for economics is a well-deserved award to Ben Bernanke, Douglas Diamond, and Philip Dybvig. Their analyses provided critical insights about the role which banks play in intermediating the needs of depositors for liquidity and the needs of borrowers for long-term debt. A special element of their work involves runs on banks which occur during episodes of panic.

That said, there is still something to be said about excessive rationality-assumption bias in the works of Bernanke, Diamond, and Dybvig. The thing about panic is that it is typically the manifestation of irrational fear. Panic is a major behavioral issue with irrational elements being front and center. It makes no sense to minimize these irrational elements, or sweep them under the rug.

Writing during the Great Depression, John Maynard Keynes had no difficulty incorporating assumptions about irrational behavior into his analysis. A similar statement applies to Hyman Minsky, who hammered home the message that irrational beliefs and behavior lead financial markets to be fragile and economies to be prone to instability.

In contrast, the three Nobel laureates go out of their way to sidestep the importance of irrationality. Consider the work upon which the Nobel committee focuses in citing Bernanke’s contribution. In that work, Bernanke writes that his theory can explain the length and depth of the Great Depression “without assuming markedly irrational behavior by private economic agents.” In regard to Minsky’s approach, Bernanke notes that while Minsky “argued for the inherent instability of the financial system,… in doing so … had to depart from the assumption of rational economic behavior.”

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Bernanke’s remarks explicitly reflect excessive rationality-assumption bias. Indeed, in a discussion of Bernanke’s work, Minksy stated that “the appropriate question is how do rational individuals behave in an irrational world.”

Next, consider Diamond and Dybvig, especially the work upon which the Nobel committee focuses in connection with the award. Here Diamond and Dybvig appear to be a bit more open to acknowledging the role of irrational behavior than Bernanke. They write: “In contrast, a bank run in our model is caused by a shift in expectations, which could depend on almost anything, consistent with the apparently irrational observed behavior of people running on banks.” This terminology is better, but Diamond and Dybvig’s use of the adjective “apparently” reflects reticence.

In their seminal work, Diamond and Dybvig use the term “irrational” twice. The second time they write: “each agent will choose his equilibrium action even if he anticipates that other agents will choose nonequilibrium or even irrational actions.” Notice the language: “even irrational actions,” again a display of reticence through the use of a qualifying adjective.

Not to put too fine a point on it, but neither Keynes nor Minsky displayed any reticence about allowing for irrational behavior on the part of economic agents. Indeed, irrational behavior was central to the analytical frameworks which they developed.

Downplaying the role of irrational behavior is a serious mistake. Globally, we are experiencing a major episode of inflation because of irrational choices by policy makers. In addition, the global financial crisis might have been nothing more than a serious recession, but for the failure by policy makers, including Bernanke, to save Lehman Brothers from bankruptcy. I view this failure as resulting from well-studied psychological pitfalls characterizing the mindsets of decisions of major policy makers at the time.

I made this last point in my book Behavioral Risk Management. Laurence Ball, in his book The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, laid out the argument in great detail. While Bernanke has long contended that there was no way that the Fed could have rescued Lehman, in my view Ball’s meticulous account is the more compelling, by far.

The 2022 economics Nobel recipients downplay irrationality in their analyses; and this is problematic. Despite the advances made by behavioral economists in recent decades, traditional economists still exhibit “excessive rationality-assumption bias.” This issue is not just about ivory tower debates among academics. The real world costs of ignoring the psychological drivers of irrational behavior lead to serious problems, such as unnecessary inflation, financial fragility, instability, and financial crisis — all on global levels. Just look around.