Tag Archives: Behavioral Economics

Postrel’s Corollary

One upshot of the experiments Virginia Postrel has described could be the following: the more investors believe behavioral economics to be true, the more likely bubbles will develop in markets trading in assets.  As long as I’m overly confident in my own rationality and knowledge (a bias behavioral economics confirms) and as long as I think everyone else is a moron (my overconfident belief in behavioral economic theory in general) then it will make sense for me to buy assets now in the hopes of selling dearly to others later, when the rising momentum of irrationality has swept them away.

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Not Irrational Exuberance But Irrepressible Effervescence

Meanwhile, Virginia Postrel has a fascinating article in the newest Atlantic on how bubbles develop in finance. She elucidates their nature by describing some recent findings in experimental economics. The nut: it turns out that even fully informed investors will inflate the value of an asset by trying to fleece dummies in the market before it crashes. 

Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But—here’s the wrinkle—you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.

Interesting throughout.

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Behavioral Economics Explains All and Saves All

So says David Leonhardt in the Times. But let’s say you work for a firm that specializes in applying the latest theories in management and organizational behavior.  Idea factories, like HBS and Wharton, spew out cutting edge techniques and models, sending them to dealerships like Boston Consulting Group and McBain. Hordes of 22 year olds fight for the opportunity to work at the dealerships, where they are promptly turned into cubicle donkeys whose sole aim is to help businesses lower the costs of production while maintaining or improving the quality of the product.  It’s all good, there’s nothing new in any of this and you get to write “Management Consultant” on your egg shell white business card.  Yawn.  

But now you’ve read about some great new theories in management consulting, only instead of coming out of HBS or Wharton, these theories have respectable return addresses in economics and psychology departments.  As a purveyor of these theories, your social life immediately changes. Instead of saying management consultant, you get to call yourself a “behavioral economist.”  Suddenly you are a savior and David Leonhardt sings hosannahs, praising everything you have to say as the new new thing:

“The sort of deficit we’re now facing will require some pretty creative plans. Fortunately, there is a group of economists who are almost ideally suited to help Mr. Obama with this task — to come up with budget cuts that can reduce government spending without harming the quality of government services. They’re called behavioral economists.”

Why all the name changing? Why not just call them management consultants? Obviously because these are no ordinary management consultants. They don’t work for profit. They don’t help businesses. These are the holy beasts of the new paradigm, immune to the constraints of common sense and history. They are the agents of change we can believe in.  To the rescue, come forth the behavioral economists: 

“This person would work with Medicare officials to improve drug compliance. He or she would think about how mortgage regulations should be rewritten, how health insurance choices should be presented and how carbon emissions might be cut.”

And the dollar will do this, and the yuan will do that, and the rising tide of the nationalistic nanny state will lift all the subprime dinghies carrying our irrational good grey burghers. Why did our burghers buy those risky subprimes?  Such a foolish question! Obviously the behavioral economists know why! Sez Sendhil Mullainathan of Harvard: 

“It’s impossible to think of the current mortgage crisis without thinking seriously about underlying consumer psychology. And it’s impossible to think of future regulatory fixes without thinking seriously about that issue.”

I’m patiently waiting for all those behavioral economists to announce the record earnings they obtained by acting on their theories in advance of the current crisis.  I’d also like to know how the principal agent problem figures in their analysis, as well as other neoclassical explanations involving the perverse incentives endemic to organizations like Freddie and Fannie. Alternatively, they could always just call themselves management consultants. After all, I hear Goldman and Morgan Stanely are looking for better ways to run their business.

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The Normative Claims of Behavioral Economics

It is often unstated, but nonetheless true, that the fundamental normative claim of behavioral economics is that people should be rational. The guiding aim of every “nudge” is to make neoclassical economics true.The behavioral economic utopia coincides with the neoclassical. Insofar as it seeks to make people better, it makes them better self-interested rational maximizers. What it doesn’t do is aim to make people more generous, compassionate, or industrious, unless, that is, those people already are driven by those values. Nudges are about means, not ends.

Of course, now that every moron on the left grasps onto the theory, they think it supports their values. Thus we arrive at buncombe like this from Andrian Kreye at the Edge.org

The aim of behavioral economics is to develop mechanisms that can enable what is called “nudging”—the psychological control of the Homo economicus.

No no Herr Kreye–you see, the guiding aim is not psychological control of homo economicus, since the descriptive claim of the theory is that homo economics doesn’t exist. No no, the aim is mould a homo economicus out of homo irrationalis.

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To What Extent Does Behavioral Economics Explain Mania in Finance?

I say very little, but I’m willing to be convinced. One very implausible, but popular line of reasoning runs along these lines: neoclassical economics assumes every agent is rational and fully informed; the euphoria inflating the real estate bubble was obviously not rational; therefore, neoclassical economics fails to explain the current crisis. Having reached this conclusion, it’s only a short step to the corollary that free markets create catastrophic social consequences.

When Alan Greenspan confessed before a congressional committee that he had revised his assumptions about economics in light of current events, people, notably those on the left, took his mea culpa as the symbolic end of a paradigm. Here at last, in public, a former disciple of Ayn Rand, the prophet in the age of turbulence, had finally announced what all those good gray burghers in coastal college towns long suspected: the science of economics is no science at all. Call off all the bets! Anything goes! In Thomas Kuhn’s notorious phrase, normal economic science is out, revolutionary, paradigm shifting economics is in.

In this vein, Niall Ferguson offers his take on the end of Wall Street:

The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. 

But this is the weakest part of Ferguson’s analysis. His greatest insight has nothing to do with rationality assumptions. Instead, his strongest arguments about mania rely on a fairly straight forward concept: old motivations coupled with poor design. Behavioral economics was not the first science to identify the vice of stupidity. And neoclassical economics doesn’t assume away incompetence. If the idealism of internet freebooters inflated the dot-com bubble, then likewise it was a version of the American Dream that inflated this one–the property owning society. As Ferguson says: 

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

More interesting to me would be an explanation showing how this generous and confident spirit percolated not just through the financial system, but also through the the populace and their government. In the end I suspect it is less man’s behavioral fallibility that brought us to the brink, but more his good-will.

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