The Danger of Crowds

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Information markets have demonstrated the ability to outperform both pundits and polls. The idea is that noisy beliefs cancel each other out, leading to a better estimate from the group than from an individual — and that the best way to combine these various points of view is to apply market forces.

But crowds can also go haywire, fed more by psychological than mathematical considerations. Although economists give a nod to this possibility, they generally (either implicitly or explicitly) count on the power of market forces to clear the inefficiencies that these psychological considerations introduce.

An exception is Nouriel Roubini, a NYU economist who now looks like a psychic for his 2006 prediction of our current financial mess. Instead of viewing human psychology as an interesting but mostly theoretical departure from the classical economic model, he embraced it. He concluded that these human forces could lead to positive feedback loops in which things would get worse — a lot worse.

As reported recently in the Washington Post, Roubini summed up his assessment of the classic economics model with the following statement: “The rational man theory of economics has not worked.” Alan Greenspan offered a wordier but perhaps even more sobering assessment: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders.”

What does all of this mean?  We need to get to a better understanding of when and at what scale predictions from the rational economic model and the behavioral economic models diverge, which model is more likely to be correct, and how to intervene to minimize harm and maximize gain.  In the meantime, you can expect greater interest in understanding the key principles underlying behavioral economics and how they apply in various settings.

(Note: this entry originally appeared at consumerology.com)

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