Economists are often criticized for making unrealistic assumptions about the behavior of “people” in our models: it seems implausible that real people would behave as intelligently as the “people” in the models are assumed to do.
In defense of economists, I will say that at higher levels (where you start to do a lot of theory) a lot of that implausibly smart behavior is assumed because you can’t even start to solve the problems we think about without presuming a lot of smarts: it just makes the math easier. And, then as the theory advances, we figure out ways to incorporate less smart behavior into our models.
Anyway, there’s new empirical research out about this. In “IQ, Expectations, and Choice”, researchers look at the accuracy of inflation expectations, and financial choices based on that, through the filter of IQ (their sample is men only). And what they find is not pretty.
Here’s the macro issue they’re worried about:
After the financial crisis, several governments around the world implemented unconventional policy measures to decrease household leverage and increase household spending so as to avoid a liquidity trap. Policies such as mortgage refinancing programs and unconventional monetary policy aimed to affect choice through managing households’ beliefs about future macroeconomic conditions and hence stimulating consumption over savings. Unfortunately, these policies turned out to be much less effective than expected. A candidate explanation for such ineffectiveness is that many households’ expectations might not react to policy announcement merely because households make mistakes in forming their expectations and have no understanding of economic mechanisms. [emphasis is mine, not theirs]
So, they got a long-term data set from Finland, where all men have to take an IQ test for military service at age 20. Then they match that up with consumer surveys done later in life, typically around age 33. It’s somewhat technical, so let me translate:
- Higher IQ men made smaller errors in their expectations of inflation.
- Lower IQ men did not adjust their current expectations at all when their past expectations were inaccurate.
- Lower IQ men rounded their expectations more drastically.
- Lower IQ men were more likely to report implausible or unrealistic numbers for inflationary expectations.
In one sense, none of that is very surprising, so … who cares, right?
Except that theory tells us that people behaving optimally should adjust their consumption when their expectations of inflation change.
…We find low-IQ men do not respond to changing inflation expectations … These results suggest that men with low cognitive abilities might not fully understand economic incentives, irrespective of the extent to which they are informed about current and future macroeconomic variables.
This is a doozy:
… Non-responsiveness of low-cognitive-ability individuals … might result in an implicit redistribution from low- to high-cognitive abilities men when central banks or government implement policies to stimulate demand via policies that aim to raise inflation expectations. The lack of forward-looking attitudes in low-cognitive-ability individuals might also determine a lower sensitivity to policy shocks aiming to favor
forward-looking saving and borrowing choices. Hence, cognitive abilities might contribute to changes in wealth inequality over time. Limited reaction to policy interventions by many households would also be detrimental for governments that aim to change aggregate consumption and saving patterns throughout the business cycle.
That is not pretty: expansionary monetary policy might have a reverse Robin Hood effect, and policies to discourage poor saving/borrowing decisions might not help those who have the most to lose. That’s a big problem, because 1) monetary policy is a common and basic tool of countries around the globe who are presuming that it can’t be subverted by the poor choices individuals sometimes make, and 2) it’s coverage in principles is at least somewhat indicative that this is as easy as understanding macroeconomic policy can be (and it may not be easy enough).
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