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Economics are Hard


There are probably a thousand little things about finance and economics you need to know if you’re going to be a “proper” grown-up in this day and age. However, the important thing to know about economics is that it’s still something of a hybrid between a black and arcane art and a rigorous and sophisticated science and the important thing about finance is that you need to understand it before you start dabbling in it.

Right now, economics is what you’d call voodoo science – it’s a discipline where there are concrete steps and all the principles are rooted in demonstrated real-world results or at least mathematics. Intuitively, this means that if you carefully follow each step from the beginning, you end up with predictions that follow the real world somewhat. However, as anyone who has spent any amount of time watching the news or tried to follow what the dollar or the price of fuel are doing week-to-week, this is rarely the case (and even when it is, you chalk it up to coincidence).

The reason for all this is that economics is hard.

No, wait, scratch that. Economics is easy. It’s predicting the future down to the day that’s hard.
It’s a bit like trying to predict the weather. How many times have you heard your mother tell you the equivalent of the phrase “They can put a man on the moon, but they can’t tell me if it’s going to rain tomorrow”?

It’s a notion that we’re all familiar with, where the unaccountably good-looking and well-spoken meteorologist (that’s fancy-talk for weatherman/woman) on television tells us at the beginning of the week that your weekend at the beach is going to be ruined and you shouldn’t even bother trying to hang out your laundry, but by the time Friday afternoon comes along, the skies are as clear as a supermodel’s skin.

“Ha! Stupid weatherman/weatherwoman!” you scoff. “I could do a better job than that!”

And you probably could, if predicting tomorrow’s rain was all that meteorology entailed. In fact, there are statistical studies that have been done that attest to the fact that on many TV stations, the predictions on whether it’ll rain tomorrow are right about 50% of the time. You could get the same results by flipping a coin every time it looked like it might rain the next day.

The thing is that meteorology is about more than just having an unreasonably good-looking presenter tell you whether or not you should do your laundry tomorrow. The stuff they’re good at, and I mean really good at, is predicting how much rainfall is going to happen in a given year, how bad the storm season this year is going to get, whether or not emergency aid agencies should stock up on bales of hay or extra life rafts this year – that sort of thing. The models used in modern meteorology can track enourmous systematic trends like El Niño and La Niña and predict how they’re likely to rear their ugly heads in a given year and they get better all the time.

It’s all very sophisticated, mathematical and very scientific and it all works in percentages. Run a model a few times and you get a lot of useful information about this trend or that trend, but what you don’t get are exact numbers. You know storms are coming, but you can only guess at where or when they’re going to hit. The way modern meteorology works is that you can tell whether or not it’ll be a wet or dry October, but not whether it’ll be a wet or dry 12th of October.

People want to know what the science says about whether or not it’ll rain tomorrow, though, even if the predictions are going to be utterly meaningless. The result is that periodically, news programs scour the universities for suitably fresh-faced and well spoken meteorology graduates to come out, doll them up and trot them out in front of a green screen with a fancy-looking weather map so they can saucily explain that this high pressure region is hovering just over the G-spot of the nation, so expect things to get hot and steamy in the not so distant future in the naughtier parts of the country, perhaps while holding one of the legs of their black-rimmed spectacles to their lips.

What does any of this have to do with the price of eggs?


The way we look at weather is almost exactly the same way we look at economics. We listen intently at the news, at the talking head from this bank or the consultant from that financial services company, or, if we think we’re really clever, we read the Financial Review. We take heed of them, take their nuggets of wisdom to heart, but when push comes to shove, we trust their judgements about as much as we trust the pronouncements of the weatherman. Not very much at all.

Instead, we put our trust in things we know we can trust. In some places, this trust is placed in property investments. Other times, those in the know say gold is the way to go. Still others think all that guff is far too risky and it’s better to leave your money in the bank to earn interest. Others, like my late grandfather, having lived through a bank failure or two, stockpile their cash around the house as though they were financial squirrels, burying nuts for a rainy day.

As tempting as it is to try to forget about the whole thing and live life, what the economy is doing affects huge portions of your life. It can mean the difference between having a job and being unemployed, between planning a holiday or losing your house. People vote governments in and out of power based entirely on how the economy is going under their watch. Even if you believe that material things aren’t all that important to you, you have to admit that money is a bit like love, freedom or air – not constantly on your mind, unless you don’t currently have enough to get by with.

We are all at the mercy of the world of economics and finance.

It’s all very bewildering and it’s so very difficult to get simple advice that breaks it all down in easy-to-understand terms. When you’re dealing with concepts with names like franking credits, debentures, credit default swaps, GDP, amortisation or even deceptively simple terms like inflation, debit and credit, all the English you’ve been using every single day hitherto seems to fail you in this utterly alien land. This is the land economists and financiers inhabit, where bankers roam free and accountants graze at the rolling foothills.

The good news is that the basics of this world aren’t all that hard to understand. The bad news is that beyond that, it gets very complicated very quickly.

Before getting into the nitty gritty of accounting and finance and why money moves the way it does, why some people have it while others don’t and why it seems to always conspire to screw you over, we first have to establish how economics works. After all, economics is the big picture stuff, right? Well, yes and no. Economics is also about small picture stuff. Individual decisions, really.

Confused yet? I know. I’m really very sorry.

Let’s make start with the concept of the rational actor, though, and see if I can salvage something half-sensical from this mess.

Remember what I said about economics being a voodoo science? Well, the voodoo starts here. Just as in voodoo (or at least the voodoo you see in the movies – I haven’t really done my research here), where you make a little effigy or doll of the person you’re trying to torture and stick pins in various parts of its anatomy, economics makes a little doll that represents you and uses it to predict what you’ll do.

Yes, you.

Why do they do it? Quite frankly, because it’s a lot easier to use a simpler version of you made from proverbial sticks and sackcloth than going up to you and asking you what you’d do in real life in a given situation. I imagine it’s the same reason voodoo doctors stick pins in little dolls rather than going to all the trouble and effort of kidnapping people and torturing them in person. It’s a real time saver.
They call this doll Homo Economicus – the rational actor.

The reason it has this name is because of a lame little in-joke economists have. As you may already know, a real human being is biologically speaking, a member of the species Homo Sapiens, which means “Wise man” in the Latin. The doll’s name is then a pun on this name, which means “Economic man”. Yes, I too can hear the guffaws coming from the School of Economics of the local university over this little detail.

Anyway, the thing you need to understand about Homo Economicus, this soulless doll version of you is that it is a bit of a menace. Not that the doll should be in jail, would cut in front of you and deliberately drive slow in traffic or tease little children for fun or anything, but it is stunningly selfish. Remember that this doll is a simplified version of you. This doll takes no prisoners, doesn’t believe in charity and makes every decision based entirely on how to maximise its own benefit. Teamwork? Friendship? The power of believing in yourself? Those other pro-social values you were taught by Saturday morning cartoons? They don’t matter to the doll. This doll slept in on Saturdays.

Now that we’ve established that the doll will not, under any circumstances, give your mother a discounted rate at the shops unless it is getting something in return, we’ll continue the lesson.

The doll does, however, possess one good quality that you, sadly, do not always display. It is coldly rational and always makes the best decision for its own well-being. Think about all the times you’ve eaten something you know is bad for you, contacted an ex you were still hung up on, procrastinated when you should have been studying or bought a lottery ticket. The doll would have done exactly none of these things.

Now, hang on, you say. If this doll doesn’t act like me, why do economists use it to represent me? Like I said, this is voodoo science and using it is easier than following you around and seeing what you do. Just like the voodoo doll kinda looks like the person being tortured, the economic doll sorta acts like you. It’s close enough that it doesn’t make a lot of difference in most situations and it allows the magic to happen.

And by magic, I mean sums.

See, the equations only work if you assume that, on average, people work in a predictable way. Otherwise, you have to account for a billion little things that people do that don’t appear to make any sense.

And the big things too.

For instance, cooperation. Our society is built on the idea that people agree not to harm one another in the pursuit of their own happiness. The flaw in this idea is that it gives people an incentive to cheat.

After all, if everyone agrees to be nice and share the resources, everybody benefits. However, if everyone else is being nice, being nasty can have quite big payoffs for you.

Why then does society not just devolve into Mad Max style dog-eat-dog chaos?

I think it’s because on some level, most of us understand that this is not sustainable. Niceness, you see, cannot be unconditional. You cheat one too many times and people will stop being nice and seek to punish you.

The best illustration so can think of is the money splitting game and people’s reactions to it. Now, I don’t remember the proper name of the experiment off the top of my head, but the basic way it works is that you give somebody an amount of money. You then tell them that they can split the money with you any way they like, as long as you accept the amount they offer you. If you don’t like their offer, neither of you get anything.

Now, a Homo Economicus would do a cold, rational calculation on any amount offered, realise it’s greater than the big fat nothing you’d get for rejecting it and automatically accept. So if the “pot” is $10 and you’re offered $0.05, you would rationally accept the offer since it’s better than nothing.

However, try to okay this game in real life and something curious happens. When people are offered paltry sums, they get offended and reject the offer. So, offer a person $0.05 when they know you’re getting $9.95 and they will likely say no, even though it’s better than nothing.


It all comes down to the innate sense of justice we share. Maybe it’s built into our brains from birth or it’s strongly instilled by our upbringing, but none of us like to see others get away with murder, especially when it comes at our expense. Perhaps a very long time ago, our mammalian ancestors discovered that by cooperating and not competing, that everybody benefited long-term, and this sense of fairness evolved to try to enforce cooperation, even when members of the party might prefer to cheat.

Having this sense means that the people rejecting insulting offers out of pride are often doing it because punishing a miserly player of the game is worth more to them than getting the money. Even when you play the game with huge amounts of money (say $150,000 total with a $1500 offer) and the person would benefit a good deal by accepting, they still reject the offer.

If course now you’ve given Homo Economicus something new to value – fairness. How much fairness is worth can then be measured in monetary terms by watching what offers they reject and which they accept. You’ve kept your voodoo doll and made it just a little more human.

Is he still rational? I would argue yes. It’s just that he factors other things, like justice, into his thinking too, not just money. Not only that, but his thinking can be resolved into dollar amounts too, which makes it easier to do sums.

The very long-winded point I’m trying to make in all of this is that at the end of the day, economics is the study of human behaviour when it comes to decision making. It starts off with simple concepts that quickly run away from you if you’re not careful and it’s important to remember what its concepts mean and what they don’t.

At the end of the day, a rational actor is not automatically a psycho. It’s important to remember this because there are those who would argue that rational actors are psychos, therefore we must smash any system built around them. There are also those who would argue that the system built around rational actors brings many benefits, therefore it’s important to become a rational actor (which they interpret as being a psycho).

Neither argument has a full grasp of the facts.

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