Alan Greenspan discovers that human beings are … irrational!

Commentary about business and finance.
Sept. 17 2007 4:23 PM

Margaret Mead in a Pinstriped Suit

Alan Greenspan discovers that human beings are … irrational!

Alan Greenspan. Click image to expand.
Alan Greenspan

In the movie Regarding Henry, a high-powered lawyer suffers a brain injury and discovers his humanity. Idea for a sequel: A high-powered economist writes his memoir and discovers the humanity of others. Call it Regarding Alan.

Former Federal Reserve Chairman Alan Greenspan was the ultimate data hound. He made his bones constructing the most rational and information-rich economic models. The acolyte of Ayn Rand believed market capitalism was ordained to triumph in the 20th century because it spoke to human strivings in a way that collectivism couldn't. But when Newsweek editor Jon Meacham and I interviewed Greenspan last week and asked what he learned from writing his new memoir, The Age of Turbulence (see an excerpt here and an interview), he said that the experience made him appreciate that human nature is far more complex than what he learned about it from Adam Smith and The Fountainhead.

Greenspan seems to argue that since the case for capitalism is so overwhelmingly rational, the opposition to it must surely stem from very deep-seated, immutable characteristics. "And that carries me to the general conclusion that if you're going to model an economy, you have to do far better in understanding how the unit of the economy functions—i.e., the human being."

As he compiled the book, Greenspan lifted his eyes from spreadsheets and data sets long enough to notice certain universals in human behavior—beyond profit-seeking. "When you get to be my age you see teenagers who replicate each other generation after generation, and it's all crazy and idealistic in the same ways," he said. Greenspan also recalled his discovery that people in all sorts of isolated societies smile, and that when Lewis and Clark encountered the Indians of the Northwestern United States, they found certain commonalities: "These were societies that truly grew up without contact with the rest of the world."

Greenspan also turned to psychology and anthropology for explanations of economic irrationality. The erratic behavior of investors during and after bubbles—excessively exuberant on the upside, unwarrantedly pessimistic and fearful on the downside—continuously confounds economists. In his memoir, Greenspan mounts a spirited defense against critics who charge that he too cavalierly let bubbles inflate on his watch. His response: Bubbles, while "extraordinary human behavior, which is not what we could consider ideal," must be innate. They seem to break out everywhere—again and again. "There's a long history of forgetting bubbles," he writes. "But once that memory is gone, there appears to be an aspect of human nature to get cumulative exuberance." When the bubble inevitably breaks, as reality fails to meet expectations, "the result is a dramatic 180 degree switch from exuberance to fear."

So what should we learn from bubbles, aside from the fact that they can be great for the economy? The phenomenon, he said, "is ever increasingly suggestive that these market economies are run by consumers, mainly by the innate characteristics of human nature."

Looking to human nature also helped Greenspan solve a perplexing economic mystery. Over the last 150 years, it seems that the maximum productivity growth the economy could achieve over a long period of time was 3 percent annually—despite a series of productivity-enhancing innovations, from the steam engine to the Internet. His conclusion? "What ultimately looks to be the case is that's the pace at which human beings operate," he said. People simply can't process new ideas more quickly. "The answer is that the human race, no matter how one defines it, is not smart enough to do better."

The ultimate rationalist seems to have concluded that fear, resistance to change, exuberance, and human limitations play a bigger role than expected in economic development. And he recognized that economists have proven so human—i.e., fallible—in their forecasting because the force  actually driving  the economy is humans who are prone to act on emotion rather than reason. The inability to account for exuberance and fear—"huge unknown variables"—is one reason why economists do poorly forecasting recessions and other economic reversals. "I've been forecasting for 50 years and I have not seen any improvement in our capability of forecasting," he said.

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