The irrational ape

While we lament the collapse of the economy, at least one group is probably feeling mildly amused at being spectacularly vindicated - behavioral economists. With Nobel prizes having been awarded to such proponents as Daniel Kahneman, it isn't exactly like behavioral economists are living in obscurity. However, the current economics woes add tremendous weight to their view of an irrational world, and perhaps conclusively shifts the winds in favor of less idealistic world views.

Behavioral economics postulates that people are not rational, as assumed by most classical economics. Instead, that people have a lot of quirks. I happened to read a couple of interesting books recently that cover some of these quirks.

The first of these tomes is Predictably Irrational by Dan Ariely. Dan Ariely's book does a good job of covering some fascinating human quirks. Here's a summary of some of the key ones:

• The first one covered is fascinating for marketers. It turns out that people have no absolute assessment of value and only understand value in relative terms. In fact, so much so, we favor options where we have something to compare the option to, even when there is no absolute reason for doing so.
• The second is the principle of anchoring. When determining values we tend to anchor to numbers, even random numbers, as a starting point, and once we anchor the effect persists. So, values are not really driven just by supply and demand, but what we anchor to. And once we anchor, we start indulging in arbitrary coherence - i.e. we want everything else to be relatively coherent to the anchored value.
• The third phenomenon discussed is that we don't treat zero or free as just another value, but suddenly suspend all rationality when something is offered for "free". In fact say something is offered for 1c and then is offered for free, our reaction to the latter is irrationally different from the former.
• One of my favorite chapters dealt with how we react differently when we use social norms vs. market norms. It's the difference between buying your mother-in-law a gift vs. giving her the cash. We are often happier doing things on a social basis, which we would be unhappy to do if money entered the equation. The insights in this chapter have significant implications for the trend towards socially conscious management. For one, it raises questions about the efficacy of social marketing and some of the moves towards developing better employee relationships through social rewards.
• One of the fairly obvious chapters was his description of experiments that people actually take very different decisions when aroused than when not. I was amused that anyone ever thought that they wouldn't. It suggests that avoiding situations where you could aroused is usually better than trying to exercise self control once in the situation. It also suggests that it may be better to arm teenagers with protection, than to rely on the better angels of their nature. Duh!
• Another chapter that made me wonder how old researchers were, was the chapter on procrastination and choice. Essentially, Dan Ariely shows that a certain amount of control and discipline is better for us than complete choice and anarchy. Huh? Most students know that, in fact, we deal better with more structured courses than ones with complete freedom to choose. I was surprised that he found it so surprising.
• He also shows that we irrationally over value what we already have, and that the more effort we put into it, the more we value it. Again, something we should already be aware of, but in this case, it's worth a look at some of the irrational decisions we may take about what we consider our own.
• His discussion about people's irrational reluctance to close options was disturbing. It reinforces my view that options thinking and understanding how to evaluate opportunity costs should be made required reading at a much earlier age. Our desire to keep options open makes us irrational and drives us to give up a bird in hand for the prospect of one in the bush.
• One of the more fascinating chapters in the book was one dealing with expectations. He discusses how our physiological experience can be fundamentally altered by our expectations. A corollary was a discussion of the "placebo effect". Our belief that something is better may actually make it work better. For instance, we may believe a 50c aspirin is better than a 5c aspirin, and so a 50c aspirin may actually work better. It suggests that something has a placebo effect is not really the same as saying no effect.
• My favorite bit though was his discussion of why people are honest or dishonest. He essentially shows that most people try to be honest, and tend to be more honest if reminded about social norms; that people's tendency to be dishonest is not related to a cost-benefit analysis of how easy or tough it is to get away with the crime. What seems to be a bigger measure is how clearly the cost of the crime on the victim is apparent. Very interesting, particularly the example of how airline companies don't equate repricing of rewards points with theft - which is exactly what an arbitrary cash deduction of equal value might have been called.

While I have listed some of the insights in a very dry list, the book uses highly entertaining experiments in a marvellously accessible way to illustrate these and other points. All in all, a very good read.

My issue with the book is that Dan Ariely clearly has a view of the world and seems to be looking for confirming evidence. In a few of the cases, he uses analogies, which appear to be predicated on his view of the world, than conclusive evidence of the opinion he is postulating. The other issue was that the book does not tie these ideas together into any coherent world view. In the end, you come away with some very interesting but disjointed quirks, but it isn't immediately apparent how these are usable.

The other book I read is Sway by Ori and Rom Brafman. Now, unlike Predictably Irrational this is not as peppered with experiments. It is significantly shorter and at least tries to tie the points together using the device of a plane crash in which over 500 people died. Here are some of the key insights:

• People do not react to equal magnitudes of upswings and downswings in the same way. We are ridiculously averse to the idea of a loss, and take irrational decisions trying to avoid losses. In fact, once we commit to a strategy of avoiding loss, we tend to double and redouble, rather than admit a loss and calling it quits, leading to utter ruin.
• Perhaps the most disturbing section in the book was its discussion on how we tend to let our preconceptions and labels drive our assessment of value, to a point where even the most rational of us seem to be physically incapable of seeing and accepting even the most compelling evidence that contradict our apriori preconception. In some cases, this label occurs through first impressions or some label assigned by someone else. Once we have a label, its almost impossible for us to be objective. What's even more interesting is that in many cases, the labels not only affect the judgment of the labeller but also the labellee, often affecting the person being labelled in a way that makes it a self fulfilling prophecy.
• In another section, they discuss how people's deep rooted belief in fairness makes us resent and act irrationally when we perceive a process as being unfair, no matter how fair the final outcome, and vice versa. In fact, they go onto show that our evaluation of many situations depends more on the process than the outcome, and that our evaluation of the process depends on our familiarity with it. Essentially, one of the corollaries is that managers who create more visibility are going to get rewarded more, because they create more clarity about their process. Logically though, it's better to focus a lot more on the outcome than the process, as we might otherwise take incorrect decisions.
• Again, like Predictably Irrational, the authors in Sway discuss social norms vs. market norms, and again, they show that people react very differently to the two and that in some situations, social norms are better motivators than financial rewards. Personally, I preferred the discussion of the implications in Sway more than the Predictably Irrational, although the latter described some fascinating experiments on this subject.
• Another phenomenon that was fairly intuitive was the idea of group think. Essentially, people don't like to disagree with the group and don't disagree unless they feel they have permission to do so. It's a bit like the Emperor's New Clothes. Dissenters keep quiet, until someone, even a little boy, points out the obvious.

The good news about Sway is that it is very accessible and very short. The bad news is that its attempt to tie everything to the plane crash is extremely tenuous, and many of their examples really stretch the analogy. I commend the authors for their laudable attempt to tie research to practical aspects of management, and while their advice is generally good, in many cases, they seem to be generalizing the point more than warranted by the evidence that they present. So, I would be cautious in its application.

Both books are fun though, and definitely worth a read - although, I still like Daniel Gilbert's Stumbling on Happiness a good deal more.

It isn't clear how representative of the field of behavioral economics, popular books such as these are. Assuming that they are a fairly good sample, it strikes me that though behavioral economists have successfully poked holes in classical economics, they don't necessarily have a compelling alternate view that can adequately replace current models. Until they do, these ideas, while interesting, will ultimately not define the practical application of economic theory.

Worse than the Great Depression?

How bad are things? Well, in some ways its not quite as bad as the Great Depression. Unemployment now is officially around 7%, although including hidden unemployment its probably more like 14%. In the Great Depression, unemployment had touched 25%.

However, in other ways, economists are beginning to point out that it's much worse. Why? Well, for one things are moving faster than anyone imagined possible. Volcker points out that the global fall in industrial production is unprecedented and breaks even the worst doomsday predictions. George Soros points out that there is no end in sight to the financial crisis. The market capitalization of the banking sector now hovers at about what the government has pumped in.

The trouble is that admit that they don't really know what will work. At this point, everyone is trying their best and hoping a lot.

The stimulus package is too small

OK, I've said it before, and I'll say it again - the stimulus package passed by Congress is too small. President Obama should consider a second stimulus, and consider it fast. Don't believe me, here is the assessment buried in the minutes of Federal Reserve's most recent meeting of its open market committee:

“All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation.” [emphasis added]

Paul Krugman, who admittedly is not a fan of the scaled down plan, points out that with the package in place, the closest parallel is the Panic of 1873 which was a 5 year recession. That would mean we could be in a slump till 2012.

Even otherwise, this makes it seem as if what the administration is shooting for is not recovery but stabilization. Not very inspiring!

Crash course

If you would like a quick and interesting view of the economy, particularly how extraordinary today is in the historical context, then this might make interesting viewing.

Essentially, what Chris Martenson is showing is that our current economy is based on growth, and due to the large base, it requires larger and larger absolute increments to sustain. In fact, though, our use of resources is now reaching proportions that are entirely unsustainable. Something has got to give.

It makes interesting viewing. The historical context is absolutely fascinating.

A breakdown in classical economics

Very nice article by David Brooks, neatly summarizing the breakdown in classical economics and why the answers to the current crisis may lie more in behavioral economics.

Fear of cliffs

If you expected an article about the white cliffs of Dover, you will be sorely disappointed. I am referring here to cliff events in the context of the economy.

In recent days there have been frantic efforts by many in the government egged on by many reputed economists including advocates of free markets to intervene in the market and prop up failing institutions. They have intervened, but seemingly to little effect. What's going on? Why is there such a panic?

Underlying the theory of free markets is an assumption that free markets, even when not perfectly efficient, are mean reverting. This is why advocates of non-intervention speak of "market correction". The idea is that while there can be a distortion in value for a time, ultimately everything will automatically revert to a true value. Of course, this view assumes the existence of such am invariant 'true value'.

There is, however, a more interesting set of theories that have been evolving that postulate that natural systems, including financial markets are chaotic. This means, that while they may occasionally appear to be mean reverting, there is no reason that they should revert to a mean. Instead, even small changes can have extremely magnified effects resulting in a different level in the long run. In such systems, small changes can have huge, often catastrophic effects. Examples of such chaotic changes are literally the straw that breaks the camel's back or the butterfly effect. In this view, there are times when a financial system like the economy can stand at a brink, where on one side, it seems unwell but curable, and on the other it faces complete ruin.

Let me illustrate with an example.

In the early part of this decade, as Enron devolved into a financial debacle, disclosures made to ratings agencies put the ratings agencies in a quandary. On the one hand, if they continued to maintain the same credit rating, then it was possible that in the interim time the company could find a way to pull itself out of the mess. On the other hand, if they reduced the rating, then it would automatically trigger a series of obligations that would hinder Enron's ability to borrow. The resulting mess would lead to further downgrades, and so on, quickly reducing Enron to junk bond status.

This was an example of a credit cliff. It's a situation where a small change in the conditions, i.e. Enron's credit rating, could push it over a cliff.

Two things to note.

• Firstly, the cliff was characterized by the value was driven belief that was ultimately self referential - i.e. it had value because people believed it had value. It was solvent as long as people believed that it was and would continue to be solvent.

• Secondly, the fiction was ultimately unsustainable.

How does this relate to the US economy? Well, you see, all those panicking economists are actually worried that the US economy is at such a cliff. The value of US companies, US markets, US debt and ultimately the US economy is ultimately dependent entirely on everyone's belief in the US economy and its ability to survive this crisis.

The problem is that the US economy as a whole is over-leveraged and over valued. The US need a HUGE amount of money to dig itself out. The only way for the US to get that money is that everyone continues to believe in the US.

With huge foreign holdings of US debt and US investments, if people suddenly started to doubt the US and started to disinvest, then the US economy could, in theory, collapse. The problem is that unlike the mean reverting view, in this view, the new equilibrium would leave the faith in the US economy so damaged that it would permanently destroy the US economy's value, and the US would never completely recover.

The Fed's experiment with Lehman caused a crash that has everyone spooked. They won't try it again. No other large US brand name can be allowed to fail. What the US government, Fed and all those illustrious economists are hoping is that if they can just hold on long enough, things will get better. They are banking on the assumption that it's in no one's interest to let the US fail. The alternative is a complete collapse of the US economy.

Are we really at such a cliff? Who knows? But you don't really want to find out by stepping off the ledge, do you?

However, note that all these interventions maintain a fiction. They keep you on the right side of the ledge. They don;t get you further away from the ledge. In fact, in some ways, they lift you up a bit, making the fall, if it comes, all the worse. So long as there is no catastrophic collapse of the economy, you could say these measures are working. But you are still at the edge.

To fix things, we still need to fix the underlying problem - asset price inflation. There are only two solutions. Either let the asset prices deflate. Or, let them stagnate until the value increases to the price. Neither is attractive. Both take time, maybe years. And, remember the second lesson from Enron is that ultimately the fiction can only maintained for so long. Let's hope the creditors of the US economy are more patient.

The sky is falling!

Volcker, the former Fed Chief says the US is in recession. Reactions to the recession forecasts have been strong. Gloom abounds. People are running around panicking like chickens. Conservatives are making gloomy predictions about how this will play out. In a recent article on the economy, David Brooks makes one such attempts at soothsaying. He predicts that Obama will ride this tide to a liberal overreach which will be followed by a conservative backlash. Very plausible.

Meanwhile, another interesting philosophical debate wages between liberals and conservatives, about whose view of the economy is right.

The liberals are crying vociferously that this means the end of free markets and the GOP approach to economics. They say it proves the GOP theories failed.

Meanwhile, the Libertarian fiscal conservatives are shouting that Bush is leading America to socialism, as illustrated this article on Ron Paul's economic adviser railing against Bush's socialism.

In a recent article on CNN, Jeffrey Miron, makes his case for free marketers, and waxes eloquently on why bankruptcy not bailout is the answer. Essentially, he points out that the bailout will reward the worst excesses and thereby facilitate the return of such excesses. By letting banks fail, you ensure that the system self corrects itself to a state where everyone is more prudent. You won't get good behavior, if you bail out the offenders every time they slip up. He also suggests that efforts to intervene will either distort the market or fail completely. On the whole, he advises doing nothing.

Others though are less sanguine. George Soros and others are pointing out that the free market system assumes that markets are self correcting. However, Soros suggests that the evidence is that markets are not. That to be self correcting they need regulations that ensure that the players play by the rules.

Others like Sloan point out that what is happening is just normal market correction and the cries of socialism or calls for re-examination of the whole structure of government are premature and unwarranted.

Meanwhile, Nassim Taleb is challenging one of the fundamental tenets of derivative pricing and thinks their Nobel prize should be revoked. Taleb's explanation is that the formula used by Merton, Black and Scholes was a widely known formula for Markov chains, and they merely applied it to economics. Further, he points out that the data shows that the Black Scholes approach is fundamentally wrong, as it assumes the distribution of rate changes is normally distributed, when in fact, the data shows that there is a significantly higher probability of extreme events than predicted by Black-Scholes.

So, which view is right? From a Scientific perspective, all the theories have merit. For instance, Supply-side and Keynesian economics both work. There is mountains of evidence that both do. There is mountains of evidence that blind adherence to one or the other doesn't. In the Asian crisis in the mid 1990s, Malaysia and Thailand went in opposite directions, and the results for their economies was much the same. So, net net, the economic theories seem a wash.

The reason of course has to do with the fact that these debates fail to realize two essential elements of economic theory. The first is that while economic theory can help frame up the debate about what could happen if you did A vs. B, it says nothing about which is better. What would happen is a scientific question and amenable to testing, whether it is good is a moral question and a choice.

For instance, raising taxes indefinitely would in fact reduce growth. However, not providing services like social security, defense, basic infrastructure, etc. for the economy, could be devastating for many people. So, taxes are necessary, too much is not. There is of course a trade-off. How much is good? The answer is how important is protecting people, providing healthcare etc. vs. making lots of money? By the way, it can be shown that at a certain point, the infrastructure will fail to the point that incremental tax breaks will no longer generate growth, but will retard growth.

The choice therefore is a moral one.

In a pure free market system, the length of the recession can be very long and the interim downward spiral would punish a lot of market participants. The people hardest hit would be those at the fringes, i.e. the poor and the middle class. If things were allowed to play out, ultimately it might correct, but not before wreaking devastation on huge numbers of people. The reason pure free market economics has never been applied in full is that whenever things get bad, the usually powerless populace reacts badly, voting out or throwing out the government and demanding change. The longer free market approaches are tried in bad times, the more political instability it creates.

Supply side economics works too. It enriches richer people first and prioritizing the plight of poor people lower. Ultimately everyone benefits. Given the incentive to rich, means that powerful market participants invest heavily, driving investment and growth. However, in general, while the benefits do trickle down, in most economies that have tried this, income disparities have grown, not shrunk. Ultimately, what that means is that poor people have substantially lower risk tolerance and richer people (i.e. people who drive the economy) have substantially higher. Ultimately, when the people in power can no longer empathise with people who are not, it can lead to very stupid risks - i.e. bubbles.\

Keynesian theories work too. The problem with them is that the allocation of money by the government is almost always a political decision and not an economic decision. Also, governments are notoriously bad at cutting back in good times. The effect of the two is that Keynesian intervention often creates huge market imbalances, lower productivity, higher structural unemployment (usually because giveaways reduce the incentive for people to go and find work), and significantly greater long term inflationary risk - because of government's inability to cut back. On the other hand Keynesian approach substantially reduces the impact on poor and middle class, and minimizes the risk for them.

Properly regulated and governed, in all three you can avoid the worst excesses.

These are no where near complete analysis. However, the larger point is that we need to choose what effect is desirable and choose the best tools to achieve it. No amount of examination of the tools can reveal the ideal goal.

This brings us to the second fallacy. As Soros points out, all human systems are flawed. And every decision has a measure of good and a measure of not so good. The good and the not so good can be concentrated on particular sections of the economy or spread around. Over time, the dogmatic continuation of any philosophy will create sufficient accretion of the not so good aspects where the good of that policy no longer offsets it. At that point, you need a different solution.

This brings me back to David Brooks' article. In the article, David Brooks describes the effect of an Obama government, and predicts that it will ultimately result in the revival of conservatism. It's not very clear whether he wants to pass judgment, but there is just a hint that conservatism in its purest form is the better philosophy. However, in describing the effect, Brooks has explained something else very eloquently - that governments in democracies are also market participants. The swing from liberalism to conservatism in a sense is the attempt by the market to find a balance between the evils of competing approaches. The longer we double down on one or the other philosophy, the more the imbalance it creates, and the more the need for a change in direction. So, what Brooks, describes a market place where the competing ideas seek balance and equilibrium. In this sense, democracy is enabling the free market to help drive the moral choices we make.