What is Wrong with Regular Economics?

Richard Thaler (2016), Misbehaving: The Making of Behavioral Economics, WW Norton & Company

Since Adam Smith’s time, the ‘invisible hand’ has ruled the dynamics of markets and equilibrium, at least in the academic corridors of economics. Real life economics, the way people make decisions from choices presented to them thinking about tradeoffs of their present selves with their future, of potentials gains with risks of losing has played out differently. People are not wholly rational- always knowing what is best for them, always knowing how to achieve what is best for them. If that were so, we would have less collision paths in the places we work, the people we marry and the investments we make. We think and feel, we are not intelligent enough to make balanced assessments of all options and so we make mistakes.

This idea of the blundering, floundering regular person is at the heart of Richard Thaler’s Misbehaving. When the stakes are high, the problems are complex and people are not experts, we make mistakes, we behave foolishly and we misbehave. The assumption of the pedantic rational genius is a myth, but it is also a costly myth. It is not just the accumulated mistakes of people that should worry us, but the assumptions that are made of us and the policies that are taken on behalf of us in the real world. Policy making is populated by experts who assume our rational boundaries and design structures that can trip us and confuse us. Ever since, Harold Lasswell called public policy the ‘policy sciences’ in the 1950s to the present day, discounting our irrationality and randomness of events has cost us wealth erosion, work place stress and general disharmony with the things around us.

Thaler’s enchanting narrative retells the story of how a group of young and vibrant minds began to question the neatness of the formulas and the elegance of the solutions by counter posing them with the clumsiness of understanding and confusion in vision. People behave through pattern recognition, swapping long and hard logic for short heuristic jumps, riskier and profitable options to safe loss-averse choices and making a penny’s worth by playing games that are not always moral or legal. In a world besotted with mental accounting, misremembering and biases, how can we still design public policies to make people obey traffic signals and encourage them to save more through pension funds?

Peppered with small and big milestones of understanding the real world through the eyes of economists, psychologists and sociologists, this narrative of the birth of applied behavioural science is both fun and deeply instructive. Questioning theoretical insights with the practical edge of wisdom, abstract rational powers with short sighted mistakes; it lays bare our incapacities to deal with the complex world. Therefore, what is at the disposal of an expert is sound evidence and some tricks to nudge and prod us into ways that might be good for us. In a world of bounded rationality, will power and resources, saving us from ourselves might be effective sometimes.  A wonderful read!

Deconstructing Financial Crisis

The Myth of the Rational Market, Justin Fox, Harper Business, pp. 340

Justin Fox is the editorial director of the Harvard Business Review Group and a contributor to Time magazine. In this fascinating historical narrative of the financial crisis of 2008 and the events leading up to it, Fox dissects ideas, people and their behavior. The perception of risk and the belief in market rationality is part of both economic thought and cultural history that consolidated the modern world of finance and investment. What the financial crisis did was, not only demolish fortunes, but also ideas put forth by intellectuals who battled to bring in a particular brand of capitalism.

Tracing history

The book is divided into five parts. This section-wise division elaborates the timeline leading up to the financial crisis. In the beginning of the twentieth century, it was unusual to associate the idea of market with rationality. The first serious attempt to apply the logic and reason of science into economics began with Irving Fischer. In his time, the idea that man was infinitely selfish and infinitely far sighted prevailed. Fischer took this assumption by the horns and argued that the uncertainty of the future could be ‘tamed’, if not eliminated. This was the beginning of modeling the future outcomes with variables available in the present.

Fischer’s work was taken a step forward by Harry Markowitz, who introduced the ‘statistical man’ to the market with the help of quantitative approach to investing. The world events of the time prepared such intellectual pursuit because of the emergence of strategic thinking in the Second World War. About a decade later, it was Paul Samuelson, who wrenched the idea of rational market that was on the fringes of the economic thought into the centre stage of academic research. Samuelson, who was in the habit of reading every paper that was published in the Quarterly Journal of Economics, came across the idea of ‘market randomness’. In a case of remarkable serendipity, a doctoral thesis of Henry Bechelier filled with dense description of market behavior caught his attention. He immediately recognized that the randomness of market mathematically described was similar to what Albert Einstein described about the Brownian motion of random particles. This paved the way for the belief in the market as rational and random.

Age of Assumptions

      The decades that followed were notable for two major achievements. Modigliani and Miller came up with a simplifying assumption that argued that the market behaves only based on real considerations of how an investment would actually perform, and not on the packaging of the investment. Eugene Fama, a doctoral student of the Chicago school, proposed that the investor’s choice took random positions along a bell curve. The metamorphosis of the market from being rational to random and from there to being perfect was established. It was this cherished belief that was shattered in the financial crisis of 2008. Alan Greenspan, the chief of the Federal Reserve for 14 years admitted that the economists failed to anticipate the crisis and invite government intervention because ‘it (the market) has been working exceptionally so well’.

This book is an engrossing read that pays rich tribute to well-known and lesser acknowledged economists and thinkers of the twentieth century. The history of ‘risk and reward’ that the book captures brings out a lively account of the protagonists in the financial world and the anatomy of the financial markets.

'Mind Blowing' Book!

Thinking Fast and slow, Daniel Kahneman, Penguin Allen Lane, Pg 499.

This review was published in the August issue of The CSR Analyst

Daniel Kahneman, a Nobel Laureate in Economics contributed his groundbreaking work on biases in decision making and uncertainty with Amos Tversky. The process of how the human mind works, the manifestation of heuristics and the application of different types of thinking process have been at the heart of his research. Such an exploration of individual cognition through both the fast intuitive thinking process and the deliberate logical thinking mechanism has had a significant impact in the understanding of unobserved flaws and prejudices of human intelligence. This telling revelation abou flawed intuition and quick interpretation has changed the way in which not just academics but powerful people in seats of decision making view themselves and their failure to realise their own dogmatic assumptions. That human mind is susceptible to systemic errors has made our understanding of our selves by giving us, as Kahneman remarks in the introduction, ‘a richer and more balanced picture, in which skills and heuristics are alternative sources of intuitive judgements and choices.’

The Power of Recognition

The key to understanding flaws in intuition is to primarily decompose intuition itself into a process worth scrutiny. Though expert intuitions seems marvellous to our untrained minds, every human being is capable of making excellent intuitive judgements every day of her life. As Herbert Simon remarked pithily, ‘Intuition is nothing more and nothing less than recognition.’ If intuition and the associated fast thinking process means simply skipping the steps of laborious logical thinking because we identify the pattern, then it is an extremely useful tool in the functioning of human beings. These entirely automatic mental activities through perception and memory serve us well in certain situations but give us a completely wrong picture in others. ‘Our blindness to the obvious and our blindness to our blindness’ is at the core of judgement fallacy.

Kahneman uses the concept of ‘two systems’ to understanding these two variants in thought process- the rapid intuitive understanding and the slow and tedious logical thinking. The ease of the first one and the mental effort required for the latter are dependant not only on the circumstances but also on our state of self at any given point in time. Both internal and external factors influence our choice of thinking and humans in general rely much on intuitions since they find logical thinking ‘mildly unpleasant’ most of the time. The interesting juxtaposition that Kahneman makes is between some internal factors that control our intelligence- people with greater self control usually have a greater ability to use their logical apparatus by taking control of the cognitive task at hand and allocating attention and effort efficiently even as four year old children as an experiment conveys. This association of certain personality traits and intelligence is not new but the experiments and conclusion with respect to heuristics is illuminating.

Overcoming Illusions

The pleasure of cognitive ease and inversely the strain of cognitive effort are instrumental in creating ‘illusions’ of reality in our lives. The machine for jumping into premature conclusion works with a complex system of association, memory and even lack of will and laziness. Understanding the dual self in humans has wide implications in dismantling economists and philosophers in surprising ways. The engaging read divided into five parts slowly unravels the mechanism of our cognition, the biases that favour or hinder it, the impact it has in our choices and decision making and finally the lack of recognition of our own other self. There is never a dull moment while engaging with this book since it prods and provokes us through activity based learning, enriches us through lucid interpretations and direct introduction to an astonishing range of ideas. In a way, this book encompasses the three stages in the author’s intellectual life- that of cognitive bias, alternative process through prospect theory and his recent venturing into the science of ‘happiness’. In the end, it appeals to the sceptic within us to question our easy assumptions and our exaggerated sense of understanding of the world and temper it with a more conscious effortful way of thinking and understanding that might lead us towards a more fruitful assessment of ourselves and the world around. This book is a valuable read that gives immense intellectual satisfaction to those who would like to understand the mechanism of understanding and the cornucopia that the human mind is.