Economists are now learning that austerity doesn’t work because most real people are not perfect rational actors. (More)

This is a busy time of the year at Árbol Squirrel. Although winters aren’t too severe in South Blogistan, I still gather and store extra nuts and Mrs. Squirrel puts extra fleece around our drey to keep us cozy and warm on the chilly nights. Plus BPI’s annual Solstice Festival is next month, so I have to polish and then hide my garden gnome.

So we’re saving up for the winter, pretty much like humans do. Real humans, that is, not the perfect rational actors that populate economists’ models. And Bloomberg Business Week’s Brendan Greeley reported that economists are starting to recognize the public policy implications of that simplistic assumption:

In a speech in Frankfurt in October, Peter Praet, a member of the executive board of the European Central Bank, told a conference of economists something curiously obvious. “Individual households are heterogeneous in many respects,” he said. “It is important to measure and analyze this heterogeneity because it can have important implications for aggregate figures.” People are different, he meant, and we need to understand how to understand the economy.

Praet had to state the obvious because until this year economists, in particular those who make forecasts, put their faith in models that ignored those differences. Those that the ECB and the International Monetary Fund used to predict the future relied on a “representative agent,” a single imaginary person who stands in for everyone.

The problem was that these models failed to predict the consequences of the austerity programs that several European countries adopted in 2010. It turned out that actual people didn’t behave like the imaginary proxy. Economists are learning that the poor and the wealthy respond differently to austerity and stimulus. This could present challenges to politicians. If people behave differently, then policy might have to treat them differently.

Of course economists never believed that every individual will be precisely rational in every transaction. Instead, as Tommy explained in my soon-to-be award-winning educational screenplay, economists assumed that individuals’ mistakes would balance out in the aggregate.

For example, if your current and estimated future income, taxes, and interest rates are such that the perfectly rational decision is to borrow $100 to meet current expenses, mainstream economists assume that a million people like you will – on average – borrow and spend $100. Some will borrow and spend too much and others too little, as compared to the perfectly rational calculus. But the average of all those individual household borrowing and spending decisions will be close enough to $100 that, in estimating the impact of a given policy, the number-crunchers at the Congressional Budget Office or International Monetary Fund can assume a population of rational economic actors.

As Greeley explains:

If models could assume that everyone was the same rational person, there was no need for data on how people act. And conveniently, relying on a single person made the math behind the modeling easier.

But new data show that assumption simply doesn’t hold up:

Representative-agent models had fairly accurate predictive power until the financial crisis and its aftermath. In January 2013, [Oliver] Blanchard and Daniel Leigh published a working paper for the IMF that was in essence a confession. When the fund forecast growth rates for various countries in 2010, it made mistakes, as did the European Commission. “Consumption may have depended more on current than on future income,” they wrote. The rational agent was supposed to plan for the future, confident that deficits were going down. Actual people did not. An IMF report in May looked back at the fund’s program in Greece, where real gross domestic product declined more than three times as much as predicted. The IMF’s mathematical assumptions about behavior had been wrong, the report conceded.

In other words, most real humans did not behave like rational economic actors, and their individual ‘mistakes’ did not balance out. When the economy turned sour and governments enacted austerity measures, the perfectly rational economic calculus predicted that people would borrow and spend – confident that today’s austerity would keep future taxes and interests rates low – and thus stimulate the economy.

But while wealthy people did that, working class families couldn’t:

At the ECB’s Frankfurt conference, [Christopher] Carroll presented a paper that bolstered [Per] Krusell and [Tony] Smith’s model with microeconomic data. For Carroll, people differ in one crucial way. “The marginal propensity to consume,” according to the paper, “is substantially larger for low-wealth than for high-wealth households.” Rich people behave like the hyperrational agent. They plan for the future. They save during a stimulus, thinking about the taxes to come. And they can borrow during a fiscal contraction.

Poor people are what economists call “borrowing constrained.” They tend to have more needs than are being met, so when money arrives, they spend it. When the government stops spending and credit is hard to come by, the mythical everyman, like the rich person, continues to spend. But most real people don’t have access to credit, and they hunker down. Carroll’s findings have been confirmed by other academics in the last two years who looked at Italian and U.S. data.

Rather than borrowing and spending $100 to meet current expenses, working class families tried to find ways to cut their budgets by $100. There are a lot more working class families than there are wealthy people, and those “hunker down” decisions amplified rather than balancing each other. Families spent less, so local businesses had less revenue. Businesses cut workers’ hours or laid workers off, so still more families had to spend less. Instead of stimulating European economies – as forecast by rational actor-based models – austerity measures triggered double- and almost-triple-dip recessions.

Maybe the economists should ask us squirrels to revise their models.

Good day and good nuts.