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..)

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!

Will Rogers once said that “The income tax has made liars out of more Americans than golf” and I worry that he was correct.

When I came to the US I was very excited with the tax system. I thought that as a matter of civic engagement this was wonderful ritual, where once a year citizens reflected on their contribution to the common pool of taxes — both for good and for bad.  Thinking about the benefits of taxes but also worrying about the waste and protesting against it.  Only later did I realize that the tax code is so complex and annoying that instead of thinking about social issues, taxation, and waste –it is mostly a day of annoyance (in fact more than one day) and rather than promoting civic mindedness it is mostly about tying to find loopholes in the tax code that will decrease our individual payments.  

One reason for this is that the tax code is so confusing and ambiguous (is taking your sister for dinner and talking to her about work a legitimate business expense?  What if she gives you a good idea that you later use?) that we are drawn to the details of how to fit our particular pattern of expenditures within this messy tax code — and while playing this game we also try to minimize our payment.  

So, what do we do to fix this problem?  First I think that we need to simplify the tax code to make the process less time consuming, less annoying, and maybe even making it more equitable.  Second, I think that we can ask citizens how they want the government to use their tax money.  This does not have to be 100% of the tax, and instead the tax forms can ask us how we want to allocate 10% of our taxes between education, clean energy, health, etc.  By doing so I think that we can increase the care and scrutiny that should come with tax season and more generally increase civic engagement.

Finally – I cannot post something about taxes without making some comment about how to decrease cheating.  My suggestion is to have the first question on the tax form asking us if we want to contribute $25 to a task force to fight cheating and corruption.  The people who would say “yes” to this question would have committed themselves, and some money, toward honesty — and it is likely that they would continue behaving more ethically while filling in the rest of the tax form.  And for the people who answer “no”?  Maybe they should audited.

Happy tax day

Dan

Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank later today.  You walk down the street and buy yourself a $2.95 ice cream cone. Later you also buy yourself a copy of Predictably Irrational for $25.95, and an hour later you treat yourself to a $2.50 cup of café latte. You pay for everything with debit card, and you feel good about the day – it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day.  Instead of first depositing your salary and then charging you for the three purchases, they do the opposite – qualifying you for an overdraft fee.  You would think this would be enough punishment, but the banks are even more nefarious. They use an algorithm that charges you for the most expensive item (the book) first.  Boom, you are over your available cash and charged a $35 overdraft fee.  The ice cream and the latte come next, each with its own $35 overdraft fee.  A split second later, your salary is deposited and you are back in the black – only $105 poorer.

Overdraft plans connected to checking accounts are common at most major financial institutions, and the Center for Responsible Lending estimates that this practice costs consumers about $17.5 billion in fees every year. Given these numbers, it is perhaps not very surprising that most financial institutions currently enroll their account holders into this expensive method of covering overdrafts without the customer’s consent or knowledge and that when consumers try to get out of these programs they find it incredibly difficult.  When I called the few banks I have accounts with last week and tried to un-enroll from these programs, the most common response I got was that it was impossible. Similarly, one New Jersey columnist reported that his own daughter was charged a $35 overdraft fee for a debit card purchase of less than $2, even when he had accompanied her to open her account and asked that transactions that would overdraw the account be denied. (Paul Mulshine, ‘Courteous’ bankers in for a rude awakening, The Newark Star-Ledger, June 7, 2007, at 15)

With the current financial challenges, I suspect that the people at the lower Social Economic Status (SES) are carrying a large part of the general financial crisis in terms of jobs and housing, as well as a large part of the overdraft fees related to overdraft protection plans.  Given this, it is a good sign that the Feds are finally looking at this issue.  The first thing that the policymakers are considering is whether to require banks to let their customers opt-out of the default overdraft system.  This sounds like a no-brainer.  A far better version of the rule would require banks to obtain explicit permission from their customers before enrolling them in this program, the “opt-in rule”. So when you sign up for a bank account, you are not enrolled in this program unless you decide that you want the bank to approve debit purchases you make even if you have no money in your account.  Given what we know about defaults and behavioral economics (that most people adapt the default option as their choice, and they see it as an implicit recommendation), I suspect that with the opt-out requirements, the vast majority of consumers will become part of the program and will keep on paying these high penalties, while the opt-in approach would make consumers much less likely to join these programs. Presumably, the banks know this, which is why they are arguing for the right to put all their customers into this expensive system of overdraft coverage without asking.

But of course, this is just the first step. In addition to the pending Federal Reserve regulatory proposal, Representative Carolyn Maloney (D-NY) has introduced legislation that, in addition to requiring that banks get explicit “opt-in” permission, would require warnings at the checkout counters and ATMs to allow customers to cancel a transaction before incurring a fee. It would also stop banks from clearing transactions from the highest to the lowest in order to increase their fees.  These are useful reforms that are much needed to prevent banks from taking advantage of their customers.

The banks of course are very worried about losing this income stream, but I suspect that changing the bankers’ mindset from business as usual to one where they are actually going to start seeking their customers’ trust and products that would actually appeal to their clients is in everyone’s best interest.  Adopting such programs might in fact push the banks to further improve their overdraft protection programs so that they are truly valuable for their consumers.  For example, banks might start giving consumers better access to competitively priced short- term loans, better connections between saving and checking accounts, or at least they can start alerting consumers using SMS when they are in danger of overdrawing their account. In the meantime, the Federal Reserve Board’s “opt-in” rule would be a step in the right direction.

I am teaching today in class about self control problems, and approaches to regain self control.  Here is a story of Buffett and his attempts at self-control:

Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities. We find a great example in Alice Schroeder’s “The Snowball: Warren Buffett and the Business of Life.”

Warren Buffett is a numbers-driven investor whose life choices and business decisions would make the vulcan Mr. Spock seem over-emotional. A teenage horse handicapper who grew up into a deep reader of Moody’s and Standard and Poor’s reports, Buffett is the archetypal quant: a data-processing, information-consuming, hard-thinking, analytical machine. His ability to outperform the market by basing his decisions on hard data and on an uncanny understanding of business fundamentals earned him the moniker “Oracle of Omaha.”

Buffett’s success as an investor required not only deep analysis of financial documents but also a large measure of self-control to avoid getting caught in market bubbles and panics. Buffett’s rule “buy when everyone else is selling, sell when everyone else is buying” requires enormous self-assurance to execute.

And yet, even the Oracle of Omaha is not immune to the allure of irrational behavior. He is what Behavioral Economists call a sophisticate: someone who understands his irrationality and builds systems to cope with it. (The other types of people are the “rational,” who never deviates from optimal behavior, and the “naif,” who is unaware of his irrationality and therefore doesn’t do anything to address it.)

Uncommon a person as he was, Buffett had a very common concern: he feared gaining too much weight. Rational agents don’t gain weight because they always consider all the possible consequences of all actions. Naifs plan to start their diet tomorrow.

But Buffett — who breakfasted on spoonfuls of Ovaltine — understood his predictable irrationality: people eat without consideration for the long-term effects; that’s why they gain unwanted weight. Being a pragmatic person, he decided to curtail overeating with a commitment device.

He gave unsigned checks for $10,000 to his children, promising to sign them if he was over target weight by a certain date. Many people use commitment devices to try to keep their weight down, but Buffett’s idea had a big flaw: his children, spotting a rare opportunity to get money from the notoriously frugal billionaire, resorted to sabotage. Doughnuts, pizza, and fried food mysteriously appeared whenever Buffett was home.

In the end the incentives worked: even with his children’s sabotage, the Oracle kept his weight down, and his checks went unsigned. But had he been purely rational, no commitment device would have been needed.

The first chapter of the Bernie Madoff fiasco has come to a close, with Madoff pleading guilty to 11 charges of fraud yesterday.

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. While the idea of diversifying among advisors has some merit — and it could reduce the exposure risk of another Madoff scandal — it will also make the task of managing portfolios much more difficult and much less efficient. Imagine that you have $1,000,000, split among four advisors. You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. This same effect is very apparent in what we call “the identifiable victim effect,” and it is the reason that we overemphasize the risks of a shark attack, and underestimate the risks of riding a bike without a helmet. In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in.

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we again gave the participants the opportunity to cheat, while solving a puzzle quiz — but this time we hired an actor. This actor, posing as a fellow participant, stood up at the start of the session and declared that he had solved all the puzzles. Now the question is how his behavior would influence the other participants in the room — the ones who were watching him.

What we found is that when the actor wore a plain T-shirt, which made him part of the student group, cheating increased. On the other hand, when the actor wore a T-shirt of the rivaling university, cheating decreased. What this means is that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less.

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples. Maybe they will start not letting their clients know exactly what they own and what they don’t own, or change a little bit the interest rate that they’re charging them … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

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?)

In the wake of all this public anger over bankers’ salaries, and within weeks of taking office, Barack Obama is proposing “common sense” executive pay guidelines—at least in companies receiving government money. These measures call for executive salaries not to exceed $500,000; any further compensation could only be in the form of stocks, which can’t be sold until the government is paid back. No doubt this makes us feel better to some extent, but the question is, will it work?

I think not, and here’s why: if we were designing the stock market from scratch and offering people $500,000 a year plus stock incentives, I’m sure we would get lots of qualified people who would kill for this job, and not only for the salary but also as an important civil service to maintain the financial system on which we depend. But this is if we started from scratch, which we are most assuredly not. Instead we’re dealing with existing bankers who are accustomed to millions a year plus millions in stock options. These people have made up, over the years, a multitude of reasons why this is the least that they deserve for their efforts and skills (how many people can admit to being paid much more than they’re worth?). This is a problem of relativity. To these bankers, in view of their “normal” pay, it looks like an offensive and irresponsible offer. My guess is that they will not accept these conditions, or if they do, they’ll find other tricks to pay themselves what they think are “right” and fair wages, which is what they earned heretofore.

What would I have done if I’d been the financial czar in this situation? I would try to turn over a new leaf; incentivize the creation of new banks with a new pay structure; promote the idea that bankers are not greedy bastards but have a crucial social responsibility so that a whole new generation would take this approach and want these positions. The “old bankers” who feel they needed millions of dollars to do their jobs well could try and compete in this new market, but we’d see who actually wanted to bank with them when the alternative is a new bank with more idealistic underpinnings and a better, more realistic, and more transparent, salary structure.