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Use of Psychology in Economics

Free Essays of EconomicsIt is the undoubted truth that regulating economic activities may seem dictatorial but, in some incidences, regulation of economic activities is inevitable. John Cassidy agrees with the economists who advocate for the free market economy; at the same time, he cautions of impending dangers, in case the market fails to conform to the forces of demand and supply. Notably, Cassidy describes the failure of the “utopian” school of economics in its inability to focus on the economic bubble that free market can create if it goes unchecked. Moreover, Cassidy uses a psychological argument to suggest that people who believe that they are an exception from the influences end up being the slaves of a fallen economy.

A human being is psychologically designed to crave for success and good things. It is the psychological nature of human beings to invest in the sector that yields huge returns. In the endeavor of investing, a business person may think that the forces of demand and supply will always favor him/her. Psychologically, the person thinks that he/she is immune to any shocks that may trigger the economy to lead him/her into making losses, as Cassidy (2009) points out. Therefore, if the forces of demand and supply do not favor the investor, he is left exposed to all shocks of the economy. It is the man’s nature of investing in a business that yields high returns that may create an economic bubble even in the strongest economies.

For instance, the economic bubble that affected the United States economy in 2008 recession relates to the psychological nature of human beings to get attracted to the sectors of economy that yield high returns. Therefore, when the economic bubble bursts, the economy exposes businesses to the financial crisis with high debts, low investments, and unemployment. According to Cassidy (2009), the government should regulate economic activities, so as to tame the economic bubble that may trigger the economy when every person is free to invest in the economy. For instance, Cassidy points out that had the United States government regulated the investments in the real estate, the recession could have been avoided. Notably, the forces of demand and supply may not regulate the desire of human beings to invest until they suffer. It is the suffering that the government should avoid by putting mechanisms to regulate the levels of investment in a given sector.

Sigmund Freud describes the man as a greedy creature who can exploit any opportunity to benefit self and feed his ego. However, man is rational only to take actions that benefit him and his associates. Similarly, Cassidy points out that government cannot just wait for people’s rationality to control the economy. Cassidy asserts that “realism economist” understands that free market is beneficial to the citizens of a country but there are some incidences that government control is necessary to tame the greed and irrationality of business owners. For instance, in the subprime mortgage crisis, the lenders behaved irrationally by giving loans to homeowners even before establishing credit worthiness of the borrowers (Cassidy, 2009).

Notably, the lenders are irrational, and thus Cassidy (2009), proposes that the irrationality did lead to lenders making losses because they could not settle their loans. In this case, it is irrationality on both sides. Thus, on one hand, the borrowers psychologically believed that the home prices could not fall in the short term. On the other hand, the lenders thought that the borrowers would always be able to finance the loans. Therefore, the free market economy led to the irrationality of both lenders and borrowers. Thus, Cassidy believes that government regulations could tame the irrational decision-making in borrowers and lenders.

Hyman Minsky’s Theory of Financial Instability

According to Minsky (2010), financial stability will, at some point, lead to financial instability. Minsky discusses how financial market is fragile and the effects of speculative borrowing to the stability of financial markets. According to Minsky (2010), during financial stability, the corporate organizations tend to increase their borrowing to finance their operations, speculating high returns in future. However, with time, a speculative euphoria develops in the market. Consequently, the speculative euphoria leads the borrowers to be unable to pay their loans from their business activities and, therefore, they default in paying their loans. The defaults create a financial crisis in the economy, and, thereby, financial instability occurs. To respond to the financial crisis, banks, and other lending institutions, reduce their lending to the businesses. As a result, the businesses reduce their activities, production declines, and the economy contracts, leading to unemployment. Therefore, to avoid the financial instability that occurs as a result of speculative borrowing, the government can use the insights of Cassidy to regulate people from such borrowing. Notably, the forces of demand and supply may lead to a financial crisis in the economy, as Minsky (2010) explains.

It is worth noting that Minsky’s hypothesis of financial instability can explain economic booms and recessions. For instance, Minsky explains that it is the debts that non-governmental sectors accumulate that are responsible for financial crisis. Notably, Minsky identifies types of borrowers in the financial market. First, Minsky identifies the hedge borrower as an organization or a person who is able to finance the debts from the current cash flows. The Speculative borrower is the one who can only pay the interest of the loan, but cannot pay the principal without borrowing again (Minsky, 2010). The “Ponzi borrower” borrows with the hope that the value of assets will increase to enable him to finance the loan. Therefore, if the asset prices fail to increase, the Ponzi borrower will not be able to finance the loan.

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Moreover, if the asset prices fall, the speculative borrower will not be able to finance the loan. Consequently, when the speculative borrowers default in paying their loans, they make it difficult for the hedge borrowers to access financing because banks restrict lending to all the borrowers. The above scenario explains what happens during the economic recession because banks lose money through lending, and thereby choose to stop lending. Therefore, regulating the amounts of money lenders advance to the borrowers in term of loans is necessary as Cassidy (2010), points out.

Additionally, during booms in economy, borrowers tend to increase their borrowings. However, when the economic bubble occurs, the borrowers default to pay their loans (Minsky). An economic bubble can occur when asset prices go down unexpectedly. If the prices fall, the economic bubble bursts and the borrowers default in paying their loans and the financial instability takes place in economy. Notably, it may take time before the bubble bursts and the businesses thrive in making profits, as the prices of products continue to increase. The increase in prices may make the businesses thrive, borrowers financing the loans and the economy may create employment.

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