Friday, October 31, 2008

behavioral economics and the financial crisis

David Brooks in the NYT (hat tip: Linda Christiansen)...

Roughly speaking, there are four steps to every decision. First, you perceive a situation. Then you think of possible courses of action. Then you calculate which course is in your best interest. Then you take the action.

Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest.

Yes and no. Economists-- at least, good ones-- recognize the role of "search and transaction costs": the cost of trying to improve on (highly) imperfect information. The result is a balance between investing more effort in information and doing the best we can with what we have (at low cost). A big chunk of this is judging individual moments by group characteristics-- in other words, generalizing and stereotyping, or what economists call "statistical discrimination". All of us do this sort of discriminating-- from trying to figure who to vote for, to car insurance companies trying to figure out risks and premia for various individuals.

But during this financial crisis, that way of thinking has failed spectacularly. As Alan Greenspan noted in his Congressional testimony last week, he was "shocked" that markets did not work as anticipated. "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms."

So perhaps this will be the moment when we alter our view of decision-making. Perhaps this will be the moment when we shift our focus from step three, rational calculation, to step one, perception.

Perceiving a situation seems, at first glimpse, like a remarkably simple operation. You just look and see what's around. But the operation that seems most simple is actually the most complex, it's just that most of the action takes place below the level of awareness. Looking at and perceiving the world is an active process of meaning-making that shapes and biases the rest of the decision-making chain.

Here, Brooks is speaking of what I wrote above-- or at least, a close cousin of it.

Economists and psychologists have been exploring our perceptual biases for four decades now, with the work of Amos Tversky and Daniel Kahneman, and also with work by people like Richard Thaler, Robert Shiller, John Bargh and Dan Ariely.

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Kahneman won the Nobel Prize a few years back, so there has already been a coming-out party for this crew professionally. But their work may gain more traction professionally and publicly as a result.

Brooks continues by describing Nassim Nicholas Taleb's research as depicted in his popular works, Fooled by Randomness and The Black Swan. Apparently, Taleb anticipated the highly interdependent aspect of the financial crisis. (Beyond that, many economists had warned about the dangers of govt intrusion in the housing sector-- especially when subsidies were involved.) And Brooks briefly mentions another popular book, Nudge, by Thaler and Sunstein.


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