Thursday, July 15, 2010

To a Man with a Hammer

In an article published about a month ago, Richard Thaler argued that a behavioral propensity to accept "risks that are erroneously thought to be vanishingly small" was responsible for both the devastating oil spill in the Gulf of Mexico as well as the global financial crisis. This prompted James Kwak to respond as follows:
Don’t get me wrong: I like behavioral economics as much as the next guy. It’s quite clear that people are irrational in ways that the neoclassical model assumes away, and you can’t see human nature quite the same way after hearing Dan Ariely talk about his experiments on cheating. But I don’t think cognitive fallacies are the answer to everything, and I don’t think you can explain away the myriad crises of our time as the result of them.
Dan Ariely is among the best of the behavioral economists and a wonderful communicator but, like Thaler, seems to have fallen victim to a different kind of behavioral propensity: to a man with a hammer everything looks like a nail. Consider, for instance, his recent comments on the subprime mortgage crisis:
Behavioral economics argues that... people will often make the same mistake, and the individual mistakes can aggregate in the market. Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse. It is not as if some people made one kind of mistake and others made another kind. It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now...
Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided.
There's no doubt that mistakes were made in the sense that borrowers, lenders and purchasers of mortgage backed securities entered positions that they later came to regret. But they did so because such behavior had been profitable in the recent past, not because they were expressing cognitive lapses in the manner of subjects in controlled experiments. More generally, behavior in financial markets is subject to strong selection pressures based on performance, and if deviating from psychologically typical behavior pays off consistently, then such deviations will proliferate. Laboratory experiments are therefore a poor guide to financial practices, the distribution of which can fluctuate significantly over time.
This kind of promiscuous application of behavioral economics to everything under the sun has become extremely widespread. And now two prominent behavioral economists, George Loewenstein and Peter Ubel have taken notice:
It seems that every week a new book or major newspaper article appears showing that irrational decision-making helped cause the housing bubble or the rise in health care costs... behavioral economics has spawned a number of creative interventions [but] the field has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address.
This is a point that I have made on several occasions to little effect. But the stature of Loewenstein and Ubel within the behavioral economics community might cause their reflections to be taken more seriously. And the choice is not simply one between behavioral economics and rational choice: agent-based computational models (among the earliest of which were developed by Thomas Schelling) constitute a promising alternative for the study of adaptive behavior in complex systems.


  1. I apologize to Professor Sethi for being off topic---but I feel the appointment of Elizabeth Warren as Head of the CFPA (Consumer Financial Protection Agency) is important, and I even feel so strongly as to say President Obama will be viewed as a failure as President in my mind if he doesn't choose her and get this accomplished. I won't be voting for him in 2012 if Elizabeth Warren doesn't get the job. I strongly encourage all of Professor Sethi's readers and students who care about the future of America to sign this petition to get Elizabeth Warren to head the CFPA.

  2. OOPS--here is the link I referred to above to sign the petition for Elizabeth Warren as Head of CFPA.

  3. "But they did so because such behavior had been profitable in the recent past, not because they were expressing cognitive lapses in the manner of subjects in controlled experiments."


    I can't say that I understand this statement. Isn't the recency effect that you are referring to well documented in controlled experiments? In fact, isn't it one of the most important parts of the behavioral economics literature? I know that Robert Shiller, for instance, talks specifically about recency effects in the section on psychological factors in Irrational Exuberance.

  4. Kevin, I understand why you interpreted the statement in that way but that's not at all what I had in mind. Fund managers are well aware of recency effects (and other common behavioral anomalies) and would take countervailing positions if it were profitable. What I was referring to was an evolutionary selection effect whereby money flows to those who have been successful, at the same time as their balance sheets are growing. No adjustment in the behavior of these individuals in response to past performance is required.