Simon argued, for our limited intelligence to understand fully. This means that very often the main problem we face in making a good decision is not the lack of information but our limited capability to process that information – a point nicely illustrated by the fact that the celebrated advent of the internet age does not seem to have improved the quality of our decisions, judging by the mess we are in today.
To put it another way, the world is full of uncertainty. Uncertainty here is not just not knowing exactly what is going to happen in the future. For certain things, we can reasonably calculate the probability of each possible contingency, even though we cannot predict the exact outcome – economists call this ‘risk’. Indeed, our ability to calculate the risk involved in many aspects of human life – the likelihoods of death, disease, fire, injury, crop failure, and so on – is the very foundation of the insurance industry. However, for many other aspects of our life, we do not even know all the possible contingencies, not to speak of their respective likelihoods, as emphasized, among others, by the insightful American economist Frank Knight and the great British economist John Maynard Keynes in the early twentieth century. Knight and Keynes argued that the kind of rational behaviour that forms the foundation of much of modern economics is impossible under this kind of uncertainty.
The best explanation of the concept of uncertainty – or the complexity of the world, to put it another way – was given by, perhaps surprisingly, Donald Rumsfeld, the Defense Secretary in the first government of George W. Bush. In a press briefing regarding the situation in Afghanistan in 2002, Rumsfeld opined: ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ I don’t think those at the Plain English Campaign that awarded the 2003 Foot in Mouth award to the statement quite understood the significance of this statement for our understanding of human rationality.
So what do we do, when the world is so complex and our ability to understand it so limited? Simon’s answer was that we deliberately restrict our freedom of choice in order to reduce the range and the complexity of the problems that we have to deal with.
This sounds esoteric, but when you think about it, this is exactly what we do all the time. Most of us create routines in our life so that we don’t have to make too many decisions too often. The optimal amount of sleep and the optimal breakfast menu differ every day, depending on our physical conditions and the tasks ahead. Yet most of us go to bed at the same time, wake up at the same time and eat similar things for breakfast, at least during the weekdays.
Simon’s favourite example of how we need some rules in order to cope with our bounded rationality was chess. With only thirty-two pieces and sixty-four squares, chess may seem to be a relatively simple affair, but in fact involves a huge amount of calculation. If you were one of those ‘hyper-rational’ beings (as Simon calls them) that populate standard economics textbooks, you would, of course, figure out all the possible moves and calculate their likelihoods before you make a move. But, Simon points out, there being around 10120 (yes, that is 120 zeroes) possibilities in an average game of chess, this ‘rational’ approach requires mental capacity that no human being possesses. Indeed, studying chess masters, Simon realized that they use rules of thumb (heuristics) to focus on a small number of possible moves, in order to reduce the number of scenarios that need to be analysed, even though the excluded moves may have brought better results.
If chess is this complicated, you can imagine how complicated things are in our economy, which involves billions of people and millions of products. Therefore, in the same way in which individuals create routines in their daily lives or chess games, companies operate with ‘productive routines’, which simplify their options and search paths. They build certain decision-making structures, formal rules and conventions that automatically restrict the range of possible avenues that they explore, even when the avenues thus excluded outright may have been more profitable. But they still do it because otherwise they may drown in a sea of information and never make a decision. Similarly, societies create informal rules that deliberately restrict people’s freedom of choice so that they don’t have to make fresh choices constantly. So, they develop a convention for queuing so that people do not have to, for example, constantly calculate and recalculate their positions at a crowded bus stop in order to ensure that they get on the next bus.
So far so good, you may think, but what does Simon’s theory of bounded rationality really have to say about regulation?
Free-market economists have argued against government regulation on the (apparently reasonable) ground that the government does not know better than those whose actions are regulated by it. By definition, the government cannot know someone’s situation as well as the individual or firm concerned. Given this, they argue, it is impossible that government officials can improve upon the decisions made by the economic agents.
However, Simon’s theory shows that many regulations work
In the run-up to the crisis, our ability to make good decisions was simply overwhelmed because things were allowed to evolve in too complex a manner through financial innovation. So many complex financial instruments were created that even financial experts themselves did not fully understand them, unless they specialized in them – and sometimes not even then (
If we are going to avoid similar financial crises in the future, we need to restrict severely freedom of action in the financial market. Financial instruments need to be banned unless we fully understand their workings and their effects on the rest of the financial sector and, moreover, the rest of the economy. This will mean banning many of the complex financial derivatives whose workings and impacts have been shown to be beyond the comprehension of even the supposed experts.
You may think I am too extreme. However, this is what we do all the time with other products – drugs, cars, electrical products, and many others. When a company invents a new drug, for example, it cannot be sold immediately. The effects of a drug, and the human body’s reaction to it, are complex. So the drug needs to be tested rigorously before we can be sure that it has enough beneficial effects that clearly overwhelm the side-effects and allow it to be sold. There is nothing exceptional about proposing to ascertain the safety of financial products before they can be sold.
Unless we deliberately restrict our choices by creating restrictive rules, thereby simplifying the environment that we have to deal with, our bounded rationality cannot cope with the complexity of the world. It is not because the government necessarily knows better that we need regulations. It is in the humble recognition of our limited mental capability that we do.
Thing 17
More education in itself is not
going to make a country richer
A well-educated workforce is absolutely necessary for economic development. The best proof of this is the contrast between the economic successes of the East Asian countries, with their famously high educational achievements, and the economic stagnation of Sub-Saharan African countries, which have some of the lowest educational records in the world. Moreover, with the rise of the so-called ‘knowledge economy’, in which knowledge has become the main source of wealth, education, especially higher education, has become the absolute key to prosperity.
There is remarkably little evidence showing that more education leads to greater national prosperity. Much of the knowledge gained in education is actually not relevant for productivity enhancement, even though it enables people to lead a more fulfilling and independent life. Also, the view that the rise of the knowledge economy has critically increased the importance of education is misleading. To begin with, the idea of the knowledge economy
