Ever wonder why you succumbed, yet again, to advertising hype or deceptive packaging and overpaid for a product? Or bought securities that you know were overvalued when the herd instinct was just too strong to resist?

Such irrationality is the focus of behavioral economists, who appear to be gaining greater credibility in macroeconomic circles since the housing bubble of 2008 and the ensuing global financial meltdown. They are also at the center of an age-old debate recently reignited by columnist and Nobel laureate Paul Krugman in a September 6 New York Times Magazine article titled, “How Did Economists Get It So Wrong?,” which fires a salvo at the assumption underlying neoclassical economics — namely, that free markets are inherently rational and efficient.

Krugman’s article heaps scorn on so-called “freshwater economists” — as typified by the University of Chicago economics faculty, whose ideas have dominated government policymaking since the early 1980s. In contrast, “saltwater economics” exhibits more openness to the ideas promulgated in the 1930s by Britain’s John Maynard Keynes — that free markets often behave inefficiently, are self-destructive and at times need corrective policy actions such as government stimulus spending. Rather than ascribing perfect rationality to markets, these economists say people and institutions often behave irrationally and often in ways contrary to their own interests.

While the debate between the freshwater and saltwater viewpoints in macroeconomics may sound academic, it has a significant impact far outside the ivory towers of universities. First, companies rely on macroeconomic forecasting in their strategic planning and budgeting and for gaining insight about customers and competitors. And macroeconomic theory underlies much of government policymaking. Since the late 1970s, for example, the U.S. government’s deregulation of airlines, banking, utilities and communications grew out of a tacit belief in market efficiency and rationality. The Obama administration may be the first to seriously challenge efficient market assumptions since the Reagan era of the 1980s, amid its attempt to restrain executive compensation and set up a new consumer protection agency to govern credit and debit card practices.

The debate isn’t limited to the U.S., either. This year’s Nobel Prize in economics was awarded to Elinor Ostrom of Indiana University, a political scientist, and Oliver E. Williamson of the University of California, Berkeley, an expert in conflict resolution, striking many economists as an international rebuke of the rigidly mathematical, rational-market models. “It is part of the merging of the social sciences,” Yale University economist Robert Shiller told The New York Times, echoing elements of Krugman’s argument. “Economics has been too isolated, and these awards are a sign of the greater enlightenment going around. We were too stuck on efficient markets, and it was derailing our thinking.”

Repositioning the Field

There is no shortage of opinion on either side of the argument, including a lengthy blog by University of Chicago professor John Cochrane, who was one of Krugman’s most conspicuous targets. Cochrane’s blog asserts: “The case for free markets never was that markets are perfect… [but that] government control of markets, especially asset markets, has always been much worse…. Krugman at bottom is arguing that the government should massively intervene….”

Much of the debate will indeed be played out in the public policy arena. The rational behavior framework, dominant for the past 30 years, dictates one set of public policy conclusions — the wisdom of further deregulation, for example, coupled with fiscal restraint on the part of governments. But a new framework influenced by behavioral economics might dictate others — tighter regulation, say, in addition to continued stimulus spending and different taxation. “There is much to recommend what the neoclassicists have been doing for 30 years,” says Wharton business and public policy professor Jeremy Tobacman. “But you have to be sensible and apply some intuition.”

Robert Stambaugh, a Wharton finance professor, cautions that the rational markets point of view is just a model, “and like any model, it’s wrong — because all abstractions are deficient to some degree. The greater question is, so what?” It could be that behavioral economics will be used more now to remedy the neoclassical model’s flaws because it offers rich new insights into human patterns of irrationality. Even so, Stambaugh doubts it will replace the rational behavior model altogether. “It may be that relying on market-based solutions is a bad idea and leads to all sorts of terrible things, but it’s like that saying about democracy — ‘the worst imaginable form of government except for all the others.’ And if beating up on the rational market view of the world becomes a way of justifying a greater degree of government intervention or some theory of non-market solutions, I think we need to be suspicious.”

According to Wharton finance professor Jeremy Siegel, the freshwater market view of macroeconomics has dominated academic thinking and government policymaking in recent decades in part because behavioral economists haven’t been able to produce the same degree of analytical rigor as the rational economists have. Now that may be changing. Siegel sees the field of macroeconomic forecasting repositioning itself, with attempts at understanding how people form expectations and how periods of economic stability breed over-optimism and encourage high debt levels. “We may be moving toward a more behavioral, Keynesian way of viewing economic crises, and that would be a healthy change,” he says.

Rational vs. Irrational?

The basic elements of the freshwater/saltwater debate are straightforward. The freshwater markets viewpoint rests strongly on the efficient markets hypothesis, or EMH, as propounded by the University of Chicago’s Eugene Fama in the 1970s and later bolstered by Chicago’s best-known neoclassicist, Milton Friedman. EMH argues that in any free market, competition among investors and entrepreneurs invariably drives prices to their correct levels. EMH does not assume rationality on the part of each player, merely on the part of markets as a whole. Therefore, the rationalists argue, free markets always make unbiased forecasts, even if they prove incorrect. EMH does not say the market price is always right, merely that it reflects all known information at any given moment.

Like a natural science, freshwater economics lends itself to complex, often elegant mathematical modeling. The freshwater view is that consumers, offered an array of choices, will select the one that is best for them — a straightforward assertion that can be neatly expressed in mathematical formulae.

In contrast, many assertions made in behavioral economics are more challenging to express mathematically. “Behavioralists” argue that consumers don’t always act in their own interests, especially when they fail to understand the choices on offer or succumb to irrational impulses involving those choices. For example, employers in the U.S. had been frustrated by the low participation of employees in company savings plans, despite the benefits the plans could offer the vast majority of workers. Employee participation jumped significantly when the government permitted companies to make savings plan enrollment automatic unless an employee checked a box to opt out of it. In other words, the government policy helped companies combat an employee’s negative impulse — but such impulses are inherently vague and difficult to define.

Unlike in freshwater economics, behavioral economics focuses primarily on the bounds of rationality. Behavioral economists assert that markets are often “informationally inefficient,” with much of the inefficiency stemming from patterns of irrational behavior that cognitive psychology can document and measure. In an article titled “Behavioral Finance,” published in the Pacific-Basin Finance Journal, Jay R. Ritter from the University of Florida notes that such patterns include:

  • Heuristics, rules of thumb that people use to simplify decision-making, which are often misleading or wrong.
  • Overconfidence, especially among entrepreneurs, who may believe too strongly in their own abilities so that they overleverage businesses and underdiversify risks.
  • Mental Accounting, the separation of decisions that ought to be combined — for example, having one household budget for dining out and another for meals at home.
  • Representativeness, the tendency to put too much weight on recent experience and not enough on long-term averages. A case in point: the belief in recent years that housing prices would only escalate, despite the contrary evidence of historic averages.

So, does the recent economic crisis mean victory for behavioralists at the freshwater school’s expense? Yes and no, according to a sampling of Wharton faculty. “It has been a crisis for the entire economics field,” says operations and information professor Katherine Milkman, who specializes in behavioral decision making. Macroeconomics failed to predict last year’s historic meltdown, but equally, microeconomic precepts have long been the basis for aligning executive incentives with the interests of companies and their shareholders. Milkman argues that the misalignment of interests was a major cause of last year’s turmoil, but so was the immense complexity of mortgage derivatives and other financial instruments. “The assumption that we can perfectly anticipate future outcomes of highly complex systems is absurd,” she says.

While agreeing that macroeconomic forecasting has relied heavily on the rational behavior model in recent decades, Milkman does not believe that dependence was entirely misplaced. “In any field, it’s important to solve the biggest problems first,” she notes — and viewing people as optimal decision makers was the right way to begin. At the same time, she sees the recent failure of economic forecasting as having brought about a sea change. “Now, economics has gone from viewing humans as perfectly rational and consistent to saying, ‘People are inconsistent and flawed in making their decisions, but we can analyze the inconsistencies and factor them into a new model.'”

A Call to Arms

Justin Wolfers, a Wharton professor of business and public policy, concurs that the downturn drew attention to important flaws, not just in the efficient markets model, but also more generally in macroeconomists’ understanding of the marketplace. “The fact that there could be large-scale banking panics, that there was a shadow banking system that the regulators didn’t have a lot to say about — these elements have not been a large part of macroeconomic theorizing over the past two decades,” he notes. However, the field of macroeconomics won’t necessarily radically alter its course as a result. True, says Wolfers, “there is widespread public anger directed at macroeconomists right now, but there is also widespread anger at the meteorologists every time it rains.”

According to Wolfers, “Most of the successes of economic policy of the last two decades remain intact. For example, economic theory is now widely accepted as a starting point for analyses of law, sociology, psychology and all sorts of social issues.” Nonetheless, he argues, macroeconomics needs to become both more data-driven and more empirical, with greater emphasis on how consumers and investors behave and make decisions. Public disillusionment with macroeconomic forecasting, he adds, should be a “call to arms” for all economists. “It’s clear that the downturn entailed important issues that all economists should be thinking about and that each subfield of economics — not just macro — has something to contribute.”