Behavioural Economics? Try Biological Economics

♠ Posted by Emmanuel in at 2/18/2011 12:02:00 AM
By now, all and sundry should be familiar with behavioural economics. In contrast to homo economicus or rational economic man, real humans are subject to all sorts of foibles during decision-making processes. This body of work was most memorably crystallized in Kahneman and Tversky's prospect theory which won a Nobel Prize in Economics a few years back. If anything else, the idea of "bounded rationality" was visibly displayed by the easy fallibility of financial services workers of all stripes during the subprime crisis.

Although behavioural economics is now rightly drawing its share of adherents, there is yet another emerging field that may help our understanding of international finance in particular. No, I am not talking about neuroeconomics, though that too is an interesting area. Rather, we may be on the verge of mainstreaming what was previously esoteric in biological economics. Drawing on natural phenomena, there may be patterns in how financial markets operate that can be understood thusly. Instead of building models on faulty notions of homo economicus, how about building models drawing on nature? Lest you think this work is too high-faluting, the Bank of England has begun sponsoring work here. From Auntie:
Biology and the natural world are helping economists build new models to understand the dynamics of the financial sector and why the US sub prime loan crisis caused so much global damage. Could an understanding of ecology have helped prevent the credit crunch? It sounds unlikely, but a group of scientists working with the Bank of England believe banking has lessons to learn from biological science...

As the financial sector grew, so did the demand for talented, numerate graduates to create new and ever more sophisticated products. But the financial sector became too tangled and when the crash came, it threatened to bring down whole economies. "This was not something that our conventional models could make sense of," says Andrew Haldane, executive director of financial stability at the Bank of England. "Activity in every country around the world fell off a cliff," he says. But there was one group of people who could make sense of it.

Enter the biologists. Scientists and the Bank of England have begun to explore possible insights from the life sciences. Comparisons are being drawn between biological systems, with their complicated webs of interactions between all the different species, and with the interactions between different banks and financial institutions. "We need to think about the system as a system, rather than looking at this atom by atom, or node by node," says Andrew Haldane, admitting that pre-crisis, this had not been done. We didn't differentiate between the big and the small, we didn't really think hard about the joins between them," he says.

Until now, system-wide data collection in banking has been virtually non-existent. Regulators are hoping they can gather information to allow them to map the financial web, and spot fluctuations that could lead to an institution collapsing. Seeing banking as a biological system can also help explain why the financial world became so vulnerable.

Paradoxically, as banks grew bigger and more complex, the financial system as a whole ended up being more homogeneous. "It's rational for an individual bank to have sought to diversify its balance sheet," says Haldane. By taking on different functions, a bank spreads its risk - it is not putting all its eggs in one particular financial basket. But all the big banks were doing the same thing. "The quest for diversification by individual banks, led to the system as a whole rather lacking in diversity," Haldane says.

In biological science, a lack of diversity in a population equals a lack of robustness - and this has fuelled calls to break up the big banks following the credit crunch. Another approach is to look at the spread of disease through a population by drawing on the parallels between big banks, and the epidemiological concept of a "superspreader" - an individual who, through their contact with large number of other people, is responsible for the spread of an infection. Like the spread of an infectious or sexually transmitted disease, the crisis that struck the biggest banks had a knock-on effect to the other institutions connected to them.

"For the equivalent of the promiscuous, we have these big banks globally who have interconnections with all the other banks in the system," says Andrew Haldane. "What you need for those types of entity is a greater amount of protection up front," he says.

In banking terms, that protection requires that the interactions between institutions are kept from being so convoluted that when there is trouble, everything goes wrong at once. The challenge is how to do that in practice, streamlining interconnections and maintaining diversity.
Don't dismiss it out of hand. If it adds to our explanatory power of global financial machinations, then all the better.