Now, people are sometimes rational calculators, but often they are not. And self-interest and incentives certainly matter, but they aren't all that matters. The perspective of economists is importantly incomplete, sometimes even misguided.
That's why we need psychologists whispering in the president's other ear -- about the economy, but also about education, health care, and more. The United States needs a Council of Psychological Advisers -- a new body that would parallel and complement the Council of Economic Advisers -- to bring actual experts on human behavior into the most senior levels of conversation about how to change it.
IRRATIONAL EXUBERANCE AND NEGATIVE EXPECTATIONS
Let's start by looking at the economy. Where did our financial institutions go wrong? And why did things get so out of hand? Why was there a housing "bubble"?
Somehow, "irrational exuberance" (as described by Robert Schiller) or "animal spirits" (as John Maynard Keynes dubbed them) overwhelmed rational calculations of risk and reward. These terms give the impression that a wild card or a joker -- something completely unpredictable and capricious -- thrusts itself into an otherwise perfectly rational system, and all hell breaks loose. Well, "irrational exuberance" and "animal spirits" are just sexy phrases for psychology, and psychologists have a good deal to say about both the causes and the consequences of these forces.
Economists offer little that helps us understand why bubbles occur or how they might be prevented. They also have little to tell us about how to prevent a "downward spiral of negative expectations" that makes fear of an economic downturn self-fulfilling.
Economists largely make assumptions about the rationality of human decision-making and proceed from there. Witness former Fed chairman Alan Greenspan's admission that he was mistaken during his time at the Fed in assuming that markets operate rationally and efficiently. The recent financial crisis and its persistent aftermath make it clear that ignoring the real psychology of "irrational" enthusiasm (or pessimism) can be perilous.
A Council of Psychological Advisers could help. This is not to say that macroeconomic variables don't matter and that the behavior of the economy is completely driven by the psychology of participants. Of course macroeconomic variables matter. But they are not, and never have been all that matters.
And aside from the acute economic crisis of the last few years, what about the looming crisis that millions of Baby Boomers are entering retirement age with no pensions and accumulated savings (including 401ks) of less than $50,000? A rational decision maker would have been saving for retirement from day one, knowing that Social Security would never provide enough, even if it remains solvent. But for someone with knowledge of the psychological impediments to making near-term sacrifices in the service of future benefits, the inadequacy of American savings is hardly a surprise.
In creating a Council of Psychological Advisers, the U.S. would be following an enlightened trail already blazed by Britain and France
We can do more than smirk and finger-wag at our short-sighted peers. Thanks to research by several people -- Shlomo Benartzi, Richard Thaler, David Laibson, and Brigitte Madrian among them -- we now know how to increase dramatically the amount of money people save for their retirement. These researchers are all economists, by the way, but they are economists who appreciate the importance of psychology.