Behavioral Economics and the Economics of Keynes Wesley Pech and Marcelo Milan Department of Economics University of Massachusetts at Amherst Abstract

This paper evaluates the economic theories developed by Keynes in the light of recent research in behavioral and experimental economics. We found that many of the ideas set forth by Keynes in his economic works, especially in the The General Theory, have a sound behavioral foundation and fit broadly the actual behavior of economic agents in the real world. As a consequence, his views about the psychological processes causing, among others, the instability of capitalism, the speculative nature of financial markets, and the necessity of government intervention, are plausible and underscored by evidence concerning individual decision-making under uncertainty.

Keywords: Keynes, Keynesian Macroeconomics, Behavioral Economics, Experimental Economics, Psychology.

That Keynes paid substantial attention to the role of psychological factors when constructing his economic theories is a well known fact in the history of macroeconomic thought. George Akerlof, for example, remarked that the current development in behavioral macroeconomics has its roots and it is, to a certain extent, a continuation of Keynes’ project. He argues that (2002, p. 411):

This paper is an attempt to fill this gap, seeking to find in the works of Keynes themselves the hints and suggestions about what a realistic approach to behavior under uncertainty might be. We claim that there is strong evidence that Keynes was deeply conscious about the necessity to incorporate realistic behavioral assumptions in macroeconomic models that deals with judgment under uncertainty. Moreover, we found that indeed his research program is broadly compatible with and finds support in most of the recent findings of behavioral and experimental economics, with important consequences for macroeconomic theory and policy. A large number of experimental works has been done in areas that Keynes considered important in his General Theory. The most important psychological findings discussed in this paper regarding the economics of Keynes are the status quo bias, money illusion, money wage rigidity, gift exchange, overconfidence, conformity, the generalized use of heuristics and their corresponding biases under situations of uncertainty, and prospect theory.

The work is organized as follows: after this introduction, we will briefly discuss the different interpretations and controversies surrounding Keynes’s ideas in order to contextualize and advance our interpretation. The following section will provide a comprehensive comparison of the main behavioral tenets of Keynesian theory with the most updated findings of the behavioral and experimental economics. The next section will consider the consequences for macroeconomic theory. The final section concludes the essay.
Controversies and Interpretations of Keynes’s Approach to Economics
Since the General Theory, and even before, the theories put forth by Keynes have always been surrounded by controversies, which is not surprising considering the far-reaching impacts of his work. The IS-LM interpretation, the consumption function, the role of expectations, the real balances effect, the fundamental uncertainty, the liquidity preference, the influence of the Treatise on Probability on the General Theory, to mention just a few, have all received a large deal of attention, both in heterodox and in orthodox circles. To propose an interpretation of Keynes’s economic theories in terms of individual behavior, emphasizing the psychological dimension is no less controversial, for several reasons.

The first objection is obvious. In stressing the role of psychology we must consider the role of individuals in Keynes’s macroeconomic theories. There are no detailed methodological discussions in the works of Keynes in general, and in The General Theory in particular, that would enable one to claim that Keynes clearly avowed his commitment to the methodological individualism. Winslow (2003) claims that Keynes rejected atomism and embraced an organic approach. However, he argued that it is still possible to consider Keynes as an individualist (p. 156, fn 5, italics in the original):

The second objection is about the rationality of individual behavior. In terms of judgments under uncertainty, this is usually addressed in terms of the rationality of conventional behavior. According to Keynes, in situations of uncertainty, economic agents use conventions as useful guides to action, supported by their higher or lower degree of confidence (or weight of argument) in those conventions (Crotty, 1994). David Dequech (1999) analyzes the different uses of the concept ‘convention’ in the post-keynesian economics literature. These range from something that structures individual expectations, to individual or collective rules-of-the-thumb that lead to a convergence of beliefs. Dequech then discusses the different arguments employed to defend the rationality of conventional behavior. However, we believe that this discussion is a deadlock. Even if one considers that rationality for Keynes means ‘reasonable’ (Meeks, 2003), these debates have an intrinsic normative bias, trying to adjudicate between different behaviors in terms of what is a value judgment.

In this regard, Michele Baddeley (1999), discussing Herbert Simon, distinguishes between substantive and procedural rationality. The first is the rationality employed by actors in neoclassical models and the second the reasonable rationality used by individuals in the real world. It is worth noticing that there is a direct relationship between the concept of rationality employed in developing theories and the role ascribed to psychology. Baddeley argues that (op. cit., pp.197-198):
“Simon (1979) comments that the substantive rationality approaches underlying these orthodox concepts ‘freed economics from any dependence upon psychology (…) Keynes’s emphasis on the subjective determinants of investment, the limits to quantification and the role of conventional behavior, fits broadly into a procedural description of rationality. In contrast to the orthodox analyses based on substantive rationality assumptions, Keynes argues that scientific theories should be able to cope with real-world situations and should not force the facts to conform with theoretical assumptions.”
We take Simon’s distinction as a suitable one to the purposes of this paper, without further getting involved into these debates.¹

The third potential opposition concerns the very realm of our interpretation, namely, the explicit importance of psychology in Keynes’s works. To refute this objection, we will consider three approaches. First, we will take the comments of Keynesian scholars on the issues of psychology and behavior in Keynes’ work. Second, we will propose an exegesis of Keynes’s texts. Finally, in the next section we will compare some passages in Keynes’s works that overtly treats of individual behavior with the most important findings of behavioral and experimental economics up to this date.

The fundamental importance attributed by Keynes to psychological elements in his economic theory has not passed unnoticed in the literature. For instance, the Nobel laureate James Tobin (1980, p. 28) utters that:
“More serious, perhaps, was his [Keynes’] insistence that the marginal efficiency of capital is as much psychological as technological.”
Winslow (2003) argues that the behavioral postulates of neoclassical economics (op. cit., p. 143):
“(…) has so entrenched the set of philosophical and psychological foundations from which Keynes escaped.”
And about Keynes’s theories (ibidem):
“Both its philosophical and its psychological foundations differ radically from those now dominant. He combined these very different philosophical foundations with very different psychological foundations.”
Sheila Dow (2003, p. 210) argues that:
“The General Theory incorporates key features of human behavior under uncertainty.”

And that (op. cit., p. 212):

The purpose of this section is to identify the elements that corroborate Keynes’s psychological speculations, and show how behavioral economics can help to understand the economy from a Keynesian perspective. Also, we describe what is missing in Keynes’s view of human behavior, and what is lacking in the behavioral literature to deepen Keynes’s analysis.

From this literature, the three heuristics that caused most attention are:

Representativeness – Judgments of the likelihood of an event are based on how representative this event is within a class of events. To asses the likelihood of an object A belonging to class B, people compare how similar A is of B, that is, the degree to which A resembles B (Tversky and Kahneman, 1974). As an example, consider an individual who has been described by a former neighbor as follows: “Steve is very shy and withdrawn, invariably helpful, but with little interest in people, or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” How do people assess the probability that Steve is engaged in a particular occupation form a list of possibilities (for example, farmer, salesman, airline pilot, librarian, or physician)? It is clear that Steve’s description is very representative of a librarian, and this is actually the occupation chosen by the majority of the people as the most likely for him. Nevertheless, the number of librarians compared to salesmen, for example, is very small. This base rate analysis suggests that Steve is indeed more likely to be a salesman than a librarian, even if he is not representative of this occupation. Along with insensitivity to prior probability of outcomes (base-rate fallacy), other biases that are associated with this heuristic are: b) insensitivity to sample size ; c) misconception of randomness; d) insensitivity to predictability; e) illusion of validity; and f) misconceptions of regression to the mean (see Tversky and Kahneman, 1974 for a detailed description).

Availability - Situations in which people assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind (ibid, 1974). For instance, people think that homicides, which are highly publicized, are more common than suicides, but actually the opposite is true. As homicides are much easier to retrieve than suicides, they appear to be more frequent in people’s minds.

Anchoring and Adjustment – Estimates that people make by starting from an initial value and then doing some adjustment to arrive at the final answer (ibid, 1974). As Slovic and Lichtenstein (1971) state, the initial value may be suggested by the formulation or some preliminary computation. In either the case, adjustments are insufficient, causing bias to the estimate.

There are several passages in The General Theory in which Keynes explicitly assumes that people are not able to maximize, and therefore some kind of “mental habit” is used to overcome the problem (1964, p. 51, italics added):

In different circumstances, Keynes uses examples that suggest the use of different heuristics (1978, p. 57):

Thus, the evidence that people use heuristics to make judgments and decisions can be extended to the insights brought by Keynes in his work. Using this approach, it is possible to understand human actions as systematic behaviors instead of a set of random actions that cannot be analyzed consistently. We believe that heuristics form the basis of judgments under uncertainty, and that they provide a useful tool to analytically explain economic outcomes.