2008 was a good year for behavioral economics
Before the financial crisis of 2008, it was rather difficult to convince people that we all might have irrational tendencies.
For example, after I gave a presentation at a conference, a fellow I’ll call Mr. Logic (a composite of many people I have debated with over the years) buttonholed me. “I enjoy hearing about all the different kinds of small-scale irrationalities that you demonstrate in your experiments,” he told me, handing me his card. “They’re quite interesting-great stories for cocktail parties.” He paused. “But you don’t understand how things work in the real world. Clearly, when it comes to making important decisions, all of these irrationalities disappear, because when it truly matters, people think carefully about their options before they act. And certainly when it comes to the stock market, where the decisions are critically important, all these irrationalities go away and rationality prevails.”
Given these kinds of responses, I was often left scratching my head, wondering why so many smart people are convinced that irrationality disappears when it comes to important decisions about money. Why do they assume that institutions, competition, and market mechanisms can inoculate us against mistakes? If competition was sufficient to overcome irrationality, wouldn’t that eliminate brawls in sporting competitions, or the irrational self-destructive behaviors of professional athletes? What is it about circumstances involving money and competition that might make people more rational? Do the defenders of rationality believe that we have different brain mechanisms for making small versus large decisions and yet another yet another for dealing with the stock market? Or do they simply have a bone-deep belief that the invisible hand and the wisdom of the markets guarantee optimal behavior under all conditions?
As a social scientist, I’m not sure which model describing human behavior in markets-rational economics, behavioral economics, or something else-is best, and I wish we could set up a series of experiments to figure this out. Unfortunately, since it is basically impossible to do any real experiments with the stock market, I’ve been left befuddled by the deep conviction in the rationality of the market. And I’ve wondered if we really want to build our financial institutions, our legal system, and our policies on such a foundation.
As I was asking myself these questions, something very big happened. Soon after Predictably Irrational was published, in early 2008, the financial world blew to smithereens, like something in a science fiction movie. Alan Greenspan, the formerly much-worshipped chairman of the Federal Reserve, told Congress in October 2008 that he was “shocked” (shocked!) that the markets did not work as anticipated, or automatically self-correct as they were supposed to. He said he made a mistake in assuming that the self-interest of organizations, specifically banks and others, was such that they were capable of protecting their own shareholders. For my part, I was shocked that Greenspan, one of the tireless advocates of deregulation and a true believer in letting market forces have their way, would publicly admit that his assumptions about the rationality of markets were wrong. A few months before this confession, I could never have imagined that Greenspan would utter such a statement. Aside from feeling vindicated, I also felt that Greenspan’s confession was an important step forward. After all, they say that the first step toward recovery is admitting you have a problem.
Still, the terrible loss of homes and jobs has been a very high price to pay for learning that we might not be as rational as Greenspan and other traditional economists had thought. What we’ve learned is that relying on standard economic theory alone as a guiding principle for building markets and institutions might, in fact, be dangerous. It has become tragically clear that the mistakes we all make are not at all random, but part and parcel of the human condition. Worse, our mistakes of judgment can aggregate in the market, sparking a scenario in which, much like an earthquake, no one has any idea what is happening. All of a sudden, it looked as if some people were beginning to understand that the study of small-scale mistakes was not just a source for amusing dinner-table anecdotes. I felt both exonerated and relieved.
While this is a very depressing time for the economy as a whole, and for all of us individually, the turnabout on Greenspan’s part has created new opportunities for behavioral economics, and for those willing to learn and alter the way they think and behave. From crisis comes opportunity, and perhaps this tragedy will cause us to finally accommodate new ideas, and-I hope-begin to rebuild.
I was doing some research on price optimization and came across your blog. Despite my agreement with you that people don’t always act rationally does this mean that government regulation (to save us from ourselves) is the solution to a healthy financial system? Do you believe that regulators always act rationally, or that they’re on average more rational than the rest of the population and so they should create guidelines to protect each party in a transaction? Is it possible that deregulation per se isn’t the problem; could it be that even the minimal regulation in place gives us a false sense that we’re protected and removes self-accountability? Could regulation sometimes prevent a person from seeking as much transparency as needed from service providers?
In any case, I think that we may be over-reacting that insufficient regulation caused the financial crises. I think that whatever little regulation was in place itself was a problem that prevented customers from seeking sufficient transparency through market means. Also I don’t think it is necessary to assume rationality of all actors in a market to achieve an optimal economy. In the absence of regulation, the market would punish irrational or uninformed actors and those who fail to learn (self-accountability) are the losers. Having regulators protect such people from themselves has the opposite effect of stifling innovation and slowing market advancement. These are my observable opinions.
Thanks for letting me comment on your blog.
Taiwo
Hi Dan,
I have read your book in its German translation (Denken hilft zwar….)and found it highly interesting. With regard to dishonesty you left aside what I would call ‘preemptive retaliation’. Take insurance claims. Insurance companies are widely seen as dishonest. Most of us could probably tell stories of insurers treating us shabbily. Consequence: Next time we claim with a ‘premium’ so that after the insurer’s expected dishonesty we may be even.
Similar with travel expense claims. I can see a certain correlation between the inconvenience of travelling, the employer’s misery and our degreee of dishonesty.
And what about taxes we should pay but try to avoid and the Governements’ and buerocracies’ attitudes re spending and having their snouts deep in the trough?
Some of these arguments are, no doubt, attempts to rationalise our dishonesty. But still, life experience has some justified influence, I believe.
I am looking forward to your next publication.
Kind regards
Karl
Okay. I’m not going to submit myself to stoning here, so I’m not going to say anything like, “Alan Greenspan was right.”
BUT, I DID actually READ Greenspan’s “Age of Turbulence,” and though it looks like a monstrously boring book, it’s actually filled with a great deal of faithful historical analysis.
And the title does it justice.
I know that the Greenspan you’re talking about is a foil, so I don’t attack you for attacking him.
But if you read the man’s own words, you’ll find that he is still right.
He was bulldozer-ed by the Bush administration. He was not in favor of the tax cuts and the wild spending.
As for deregulation, it remains to be seen whether bailing out the casino/banks really does create terrible moral hazard in the future, and whether it will not have been better to just let many of them fail.
In which case a terrible depression would have ensued, but the market certainly would have corrected itself, like disaster corrects the foolhardy, like mother nature is going to correct her naughty babes
Yours,
Lilian
I am a fan,
I would think that our propensity to behave irrationally is directly proportional to our belief that we can avoid the consequences of our decisions. One might play better golf when it is understood that mulligans are off the table. The corporate do-over may not exist, but cushions do, as do escape plans that are intended to get the irrational grasshopper out of town before the snow hits the fan.
The argument that regulations might have contributed to the banking crisis is irrelevant. If existing regulations did contribute to the problem it is because they were faulty. The fact that faulty regulations exist does not mean that there is no need for proper regulation, but it may mean that there is a need for better regulators. Any one for civil service exams? They could be self corrected.
Regards,
W.R.
Hi Dan,
In your example of the Economist ad, I kept waiting for you further to assess it, yet, you never stated what was obvious to me: that the “useless option” was NOT useless. It was crucial in revealing the cost of “Print”. If the Print cost $125 and “both” (web and print) cost $125, then, the “web” is free; do the math. I’d like to see The Economist squirm out of my claim that they even provided the evidence for this. Even though the first offer was $59 for “web”, it was only a first offer. Subsequent, better offers were revealed as we read further. If anything, the “useless offer” is the first one (not the second) because the information given was ultimately proven inaccurate.
In your second ad, when you removed the cost of “Print”, (the alleged “useless option”), the math proves that the cost of “print” has, now, become $66 because both web and print cost $125 and the known factor, from the only other offer, – the “web” cost – is $59. So, the reason that the choice shifted from “both” to “web only” is because: why pay $66 for “print” when no one really wants print … and never did – particularly considering that the “web” option offered access to all back issues; they were simply going for what appeared to be a bargain (2 for the price of 1), in the original ad, yet, it was not a bargain when one considers that they could have gotten the “web” edition at no cost at all. If you read the offers from last to first, you’ll see that each stands alone and one can easily see the best offer.
With all due respect, the alleged “useless option” did not assist anyone in choosing, by including “what nobody wants”; rather, it proves that people are just looking for a bargain which, in this case, was only superficial. The real bargain was not evident. One would have to be very astute to see the real bargain.
You might enjoy my book: How I Clobbered Every Bureaucratic Cash-Confiscatory Agency Known to Man: … A Spiritual Economics Book on $$$ and Remembering Who You Are.
http://www.spiritualeconomicsnow.net/solutions/How_I_08.pdf
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Hello,
I am not an economist or a behavioral specialist, so I’m going to do the layman thing and over simplify an enormously complicated subject: as such, I’m going to focus on the word Growth.
As a layman thinking in simplistic terms, I find it shocking that supposedly intelligent people could ever consider the idea of a growth based economic structure a viable option.
Considering the idea of growth alone, one has no reason not to believe that growth could continue infinitely without qualm. However, rationality forces one to consider growth in the realm of space and resource – those factors considered, one has no choice but to admit that growth cannot possibly continue infinitely. This idea is easily accepted for the physical world, why then is it so hard to accept when applied to economics?
My point then is this: our current economic situation is not caused by over regulation or under regulation, nor will it be solved by new regulation. The problem is our idea of what constitutes a successful economy.
There is nothing rational about a growth-based economy.
My definition of financial success is much simpler: I make more money than I spend. I grow when growth is called for – not for the sake of growth.
Perhaps the “rational” economists out there would do well to think simpler.
You should check out a game called Eve Online. It is a persistent universe w/ a huge player driven economy. There is even an economist on board to help explain things. Not that you need that, but apparently the playerbase does. Look me up if you get on line. Caztra Tor is my game name. Enjoy.
I’d like to follow up Winston’s notion by suggesting that a video game or virtual world would in fact be an ideal place to conduct the sorts of economic experiments that you were lamaneting cannot be conducted in the real world.
I will caution that Ed Castranova intended to do this, but discovered that creating a game from scratch is neither easy nor cheap. Perhaps if a group of economists banded together with interested game developers, you might be able to create your experimental economics sandbox.
Dan,
My wife and I are a big fan of your book. I run a (fairly) successful financial planning practice. Your book has inspired me to return to school and obtain my Ph.D. in economics (use the rest of that GI Bill money).
I think you are accurate on a number of accounts (most, in fact).
However, lack of regulation has not been the problem. Regulation of the wrong sort has.
Lending requirements were slackened because they were deemed racist. This led to more purchasing of homes. More mortgages. More mortgage-backed securities. More leverage. Market forces responded to the huge increase in mortgages, creating many different derivative type instruments. And so on, so forth, snowball from hell, etc.
This of course, is just my opinion. Hopefully, on my way to this Ph.D., I’ll end up a little smarter. But definitely your book has made me question further. Thank you for that.