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.

Paul Krugman published an op-ed yesterday about exec salaries.

The very sad conclusion he comes to is that because the financial markets seem to be on an improving trajectory (although it is hard to know if this reflects a real improvements in the economy yet) the push to reform the banks could die off.  As Krugman puts it: “In 2008, overpaid bankers taking big risks with other people’s money
brought the world economy to its knees. The last thing we need is to
give them a chance to do it all over again.”

We are now in a unique point in time where we just realized the mess we got ourselves into by assuming that the markets will be perfectly rational — and I sure hope we are not going to forget this painful lesson just because the market seem to be slightly higher these days.  In fact, I suspect that what we need to do is take this lesson to heart and expand our search for other markets that are just waiting for similar disasters (and the health market looks to me to be heading is similar direction..)

Derek Bok, the 25th President of Harvard, famously said: “If you think education is expensive, try ignorance.” What we need is more business education, not less!

There are recent debates about the value of MBA education and I have to say that I find the notions of scrapping management education somewhat odd.  It is not that I think that management education is perfect, far from it, but its importance in my mind has only increased due to this financial crisis. Does anyone really want to suggest that the people who are running our institutions and companies do not need to learn more? That they don’t need to have specific knowledge to better guide their companies and our economy? For example, is there anyone who doesn’t think these days that executives need to have a much better understanding of accounting, and that they need to know how to read accounting statements?

From my perspective, the main lesson from this economic meltdown is that despite our confidence – we actually know very little about the operation of the financial world around us.  Moreover, it is clear that such lack of understanding, together with high confidence and reliance on the opinions of others (presumably experts) can have devastating consequences. If anything I suspect that this meltdown shows exactly how important it is for executives to have a better understanding of the world in which they operate.

Of course, like many others, I believe that it will be very useful to change the curriculum of the MBA program so that it is more useful — but if anything I would make it mandatory for executives to keep on learning throughout their careers in the same way that we require physicians to keep on improving and learning.

In terms of the actual curriculum for management education, my own view is very simple-minded: The world is incredibly complex, it changes all the time, and we should not even hope that we could create a general model that accurately describes the world in all its possible states. Instead I proposed that management education and practice should become much more experimental and data-driven in nature — and I can tell you that it is amazing to realize how little business know and understand how to create and run experiments or even how to look at their own data!

We should teach the students, as well as executives, how to conduct experiments, how to examine data, and how to use these tools to make better decisions.  For example, over the past five years or so we have learned from experimental evidence a lot about the tricks that conflicts of interests can play on us, and these findings help us understand financial catastrophes from Enron to the recent market failures (for my take on this see TED).  Given this new understanding, and we lean more and more all the time, I think it is crucial to transfer this knowledge to business executives so that they can take this new understanding into account.

Disasters are usually a good time to re-examine what we’ve done so far, what mistakes we’ve made, and what improvements should come next. If the lesson from all of this will be to blame the MBA programs than I think we would have not gained much. However if we will seriously consider how to keep on exploring and understanding the complex world we live in, and make this an inherent part of management education, perhaps the future version of our world would look better.

Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating.  The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so.  This is a beautiful idea, but the question of course is how closely it represents reality.

In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand.

In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions.  Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.

In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever. The irrational invisible hand is a different story altogether – here we must identify the ways in which irrationality plays tricks on us and make the invisible hand visible!

Sometimes asking someone to do something for nothing is more powerful than paying them.

In a research paper entitled “Effort for Payment: A Tale of Two Markets,” James Heyman and I that people are willing to help move a couch or perform an experiment just by being asked. Moreover, these individuals feel good about their “gift”. Most interestingly, the experiments show that contrary to standard economic theory, paying a small incremental incentive does not increase effort, but actually lowers it — because meager compensation profanes the gift effect and disincents the giver.

Bringing money into the relationship takes the giver’s work out of “gift” market, and brings it into the “pay-for-effort” market. When it was done for nothing, the protagonist was a “donor.” When small money was on the table, he or she became an underpaid employee. The easiest way to think about this is to imagine if at the end of Thanksgiving dinner you asked your mother-in-law how much you owed her for cooking such a wonderful meal. Would that increase or decrease her effort the next time you came by? (Assuming, of course, she would still invite back you after such an insult.)

In this financial crisis, there has been much discussion about banker’s pay. We think that if President Obama had asked for a group of bankers to take $0, and paid expenses only, it would have brought the discussion back into the gift economy. $500,000 is just low enough to bruise the banker’s egos (after all, they got used to much higher salaries for a long time, higher salaries we can be pretty certain they feel they deserved), but $0 is something to be proud of! In fact, paying these CEOs nothing might remind them about the responsibility they have to the banks they are leading and to the rest of society. The CEO of AIG Ed Liddy is already only taking a one-dollar salary and donating his time to this worthy effort. But his gift is isolated, a drop in the bucket — not part of an overall “corps” of senior financial executives acting in unison to help fix the mess.

Would the best people be willing to work for free? Not all capable bankers could afford it, but many could. We think there would be many willing to pitch in…if asked in the right way. After all, this gift idea was at the core of John F. Kennedy’s brilliant notion, “Ask not what your country can do for you — ask what you can do for your country.” By eliminating pay altogether, these leaders would be giving the nation the donation of their time and skill, improving their level of motivation. Instead of accusing them of being greedy and self interested, people could see them as important actors playing key roles in the stability of our entire economy. This in turn would probably encourage more bankers to see the power of a collective gift and the joy they could feel in donating something so important.

As it stands now, the many good people who are trying to improve things for little or no pay are isolated, their effort drowned out by the outrage over bonuses and salaries. Hence we have the Congress and President involved in legislating the level of executive compensation all the way down to its structure and timing! Congress should not be mired in the details of compensation design. Not only are they bad at it, but the beleaguered public — whose median household income is less than 1/10th of $500,000 — is watching the pay ping pong with collective disgust. The knee-jerk reaction to create a confiscatory 90% tax on the AIG bonuses makes the conservatives among us think we are killing capitalism itself.

When individuals commit acts of personal generosity, it sparks a gift culture that replenishes a store of trust — a resource as multiplicative as any Keynesian monetary policy. This sharing is not done in a communist, carving-up-the-spoils manner, but rather in the tradition of bravery and sacrifice for our collective benefit. When those in power act within a gift culture guided by a spirit of generosity for common cause, it creates a tangible trust asset that supports the flow of credit, money, and markets. By focusing on limiting executive pay, President Obama did the political equivalent of asking his mother-in-law how much he owed her for Thanksgiving dinner — and moved the discussion away from social responsibility, and into the pay-for-effort market, where the negotiations for spoils now dominate the discourse.

We think our bold young President has to improve his request. A gift culture — created at the top — will benefit all of us; and, strangely, will also help strengthen the rapacious markets where self-interest reigns supreme. The good news is, it’s not too late.

By John Sviokla and Dan Ariely

Have a look at this!  it is a rather nice account of the credit crisis

In a story that just appeared in The Atlantic, Gregory Clark, a professor of economics at the University of California at Davis, described some of his concerns with the profession of Academic Economists.
In this story he also used a paper on online dating (one of mine) to show how economists are working on irrelevant topics.  And while I think that the dating market is an important topic to study, and even more to try and improve, I think that his overall criticism is worth paying attention to.

Here is the text:

Dismal scientists: how the crash is reshaping economics
With the chattering classes consumed by concern for the devastated value of their 401K funds, and their suddenly precarious lifestyles, there has been much anger and scorn directed at those former masters of the universe, financiers.

But the shock to the world of finance has been echoed by a shock to the world of academic economics that is just as profound.

In the long post WWII boom, as free market ideology triumphed, economists have won for themselves a privileged place inside academia.

First there is the cash. It astonished some when Washington University, a school with an economics department of modest prestige, hired economists David Levine and Michele Boldrin by offering salaries well in excess of $500,000.  But most high ranked economics departments have professors earning in excess of $300,000.  Not much by the pornographic standards of finance, but a fat paycheck compared to your average English or Physics professor.

It is not just the stars.  Journeyman assistant professors in economics routinely come in at $100,000 or more. And, unlike the hard sciences, they do this fresh from their PhDs, without a publication to their name and without years of low pay as post-docs.

The high salaries have been accompanied by dramatic declines in the teaching burden.  The research demands of our advanced science leave little time for the classroom.  In good universities faculty typically teach only two courses a year – one of which has to be a graduate seminar.  The masses in the Econ 1 classes are often abandoned to the tender mercies of graduate students.

Then there is the economics “Nobel” Prize.  Not a real Nobel, but a prize funded by the Bank of Sweden in honor of Alfred Nobel, with all the royal trappings of the Nobel.  That makes economics star players really attractive to universities.  When Edward Prescott of Arizona State won the Nobel he was paraded at half time at a football game.  There is nothing like a Nobel for luster and fund-raising.

Why did academic economics generate so much prestige? Sure, modern economics is technically demanding.  But so, for example, are theoretical physics and archeology, and physics and archeology professors are (relatively) dirt poor.

The technical demands helped limit the supply of economists. But what drove demand was the unquenchable thirst for economists by banks, government agencies, and business schools – the Feds, the Treasury, the IMF, the World Bank, the ECB.  Economics had powerful insights to offer the world, insights worth a lot of treasure.  Economics was powerful voodoo.  Any major university or research institute wanted to arm itself with this potency.

The current recession has revealed the weaknesses in the structures of modern capitalism.  But it also revealed as useless the mathematical contortions of academic economics.  There is no totemic power.  This for two reasons:

(1) Almost no-one predicted the world wide downtown.  Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history.  There was indeed much recent debate about the sources of “The Great Moderation” in modern economies, the declining significance of business cycles.

Indeed as we have seen this year on the academic job market, macroeconomists had turned their considerable talents to a bizarre variety of rococo academic elaborations.  With nothing of importance to explain, why not turn to the mysteries of online dating, for example.

I myself was so confident of the consensus of the end of the business cycle that I persuaded by wife after the collapse of Lehman Brothers to invest all her retirement savings in the stock market, confident that the Fed would soon make things right and we could profit from the panic of a gullible public.  The line “Where is my money, idiot?” is her’s.

(2) The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1.  What is the multiplier from government spending?  Does government spending crowd out private spending?  How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.

The bailout debate has also been conducted in terms that would be quite familiar to economists in the 1920s and 1930s.  There has essentially been no advance in our knowledge in 80 years.

It has seen people like Brad De Long accuse distinguished macro-economists like Eugene Fama and John Cochrane of the University of Chicago of at least one “elementary, freshman mistake.”

It has seen Treasury Secretary Timothy Geithner, guided by Larry Summers, one of the most respected economists of our time, produce a bailout plan for the US financial system stunning in its faltering vagueness.

Bizarrely, suddenly everyone is interested in economics, but most academic economists are ill-equipped to address these issues.

Recently a group of economists affiliated with the Cato Institute ran an ad in the New York Times opposing the Obama’s stimulus plan.  As chair of my department I tried to arrange a public debate between one of the signatories and a proponent of fiscal stimulus — thinking that would be a timely and lively session.  But the signatory, a fully accredited university macroeconomist, declined the opportunity for public defense of his position on the grounds that “all I know on this issue I got from Greg Mankiw’s blog — I really am not equipped to debate this with anyone.”

Academic economics will no doubt survive this shock to its prestige.

Will we be as well paid?  A recent article in the Wall Street Journal suggests the days of the $500,000 economics professor may have passed.

But more importantly, will the focus of academic economics change?  That is hard to tell.  But I would rate the chances of Chrysler producing once again a competitive US automobile at least as high as the chances of academic economics learning any lesson from this downturn.  (What was the price of that Chrysler stock we bought, dear?)

Today I am working on an expanded version of my book — I am going to include some ideas about the stock market and some other random ideas

This week we learned that former Nasdaq chairman Madoff likely swindled investors out of $50 billion – arguably the largest financial fraud ever. And thinking about the gravity of the scam, it occurred to me that Madoff’s scam could be compared in terms of its effects to terrorism. Here’s how:

Consider that there was a time when terrorism wasn’t the big deal that it is now. This was before advances in technology, when terrorists only had recourse to low-level weaponry like stones and knives – which, while harmful on an individual level, are not quite weapons of mass destruction. In time, though, “better” technology came along, leading in turn to “better” terrorist tactics: suicide bombing and the like. Still peanuts, though, compared to what came later: 9/11 planes, bio terror – this is when things really got serious; now even one crazy person can cause a world of damage.

Now, I think Madoff’s case is equivalent in a financial sense. Whereas in the past one person’s monetary misdeeds could affect a handful of people at most, now there’s more at stake: a single person – like Madoff – can cause a whole lot of fiscal damage. And the reason lies in interconnections: when companies began investing with other companies, any fraud can spread and cause damage across many companies.

There’s one other similarity here. What makes terrorism so powerful are its randomness and intentionality: it can strike any time, and you never know when you’ll be a victim and it is done on purpose. Things that we can’t predict, control or at least think we can control make us more afraid. And that’s exactly the case with Madof’s scheme: the investers probably assumed that they were in control and all of a sudeen we all learned that we are much less in control, and that someone can do this to any of us.

If we view the stock market through this terrorism perspective, and we understand that just a few individuals can cause so much damage, it becomes clear that more regulation is needed – we do so much to check people at airports — shouldn’t we use the same level of security for hedge funds?

I wrote this about 8 months ago — but it makes particular sense right now ….

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If (as is often the case) talking about sex makes people more interested in having it, does that mean that the current talk about a recession could actually be creating one? Well, maybe.

Or so one general finding of behavioral economics would have us believe. With all this chatter about a recession, consumers might, for example, hold off on buying that new dishwasher because of the “bad economy,” or pass up the more expensive restaurant because “we’re in a recession.” Without any discussion about recession, we’re unlikely to change our pattern of behavior. But talking about it can be a force that affects our decisions and alters our consumption habits.What makes me think that we’re such creatures of habit? Consider the experience of eating a Godiva truffle: The chocolate is melting in your mouth, the aroma penetrates your nose, there is a small nut inside. . . . Now think about this familiar experience and try to determine how much it’s worth to you. A quarter? $0.50? $0.75? $1.25? $2.50? While the experience of eating a truffle is very familiar, figuring out what we would be willing to pay for it proves difficult. So what do we do when we make purchasing decisions? (more…)