By Simon Grey, on September 13th, 2011
 Maybe my discipline for reading has been waning in recent weeks, because this is the second consecutive book that I’ve been unable to read in its entirety before quitting. The problem with The Winner’s Curse is that it is a highly technical way of saying “duh.” By this I mean that Thaler addresses issues that are only problems for economists that apparently have no experience with actual human beings.
Economists have long assumed that humans are, fundamentally, rational creatures. Even von Mises assumed as such, although it should be noted that his usage of “rational” was tautological, and based solely on economic actor’s behavior (instead of, say, the economic actor’s stated goal) and bound by the limits of human knowledge. Basically, Mises argued that one’s “true” desires were shown by one’s behavior, and that all humans pursued the most efficient course of action to attain the desired ends.
However, mainstream economists generally tend to define “rationality” as one’s tendency to act in one’s best long-term interest. Whether this definition accounts for the constraints of humanity (i.e. imperfect knowledge, the constraint of time, etc.) varies by economist. At any rate, the assumption is that humans have a tendency and desire to act in their long-term best interest, and, furthermore, derive only (or mostly) direct utility from consumption.
These assumptions are wholly fallacious, and contradict observable reality, which creates quite a problem for economists who try to make detailed policy prescriptions, since doing so generally requires the ability to correctly predict micro-level behavior. Obviously, economists have largely been unable to do so, in part because they bought into the myth of the average person, and in part because the average person does not resemble an actual human as much as it resembles a watered-down version of what economists think an ideal human being would look like.
Thus, much of what has been written about theoretical human behavior from an economist’s standpoint has been largely irrelevant and useless to those who live in reality because economists desire a reality that does not exist. One example of this is what’s known as the Ultimatum Game. The game is played by taking two people, giving one of them a sum of money, and telling him to split it however he chooses with the other player. If the other player accepts, they split the money accordingly and go on their merry way. If, however, the other player declines the offer, neither player gets anything and they go on their unmerry way. Theory dictates that the most rational course of action is for Player A to offer Player B one penny and for Player B to accept, with the idea being that one penny is better than nothing.
But when put into practice, as Thaler details quite extensively in his book, the offer is rarely a penny. It is usually substantially more than that (close to 50% in many cases).
It turns out that humans are more complex than economists would lead you to believe. Many humans, it appears, have more than a direct pecuniary interest in monetary offers. This shouldn’t be surprising, since humans are social creatures with a rather common need to show off. Non-economists tend to recognize this, and therefore make a point of making an offer that is not perceived as insulting. If an offer were too low, the recipient would decline it because the recipient would perceive the value of the money to be lower than the value of the social communication that declining the offer would bring (i.e. the recipient would find it more useful to say he’s insulted than to accept the money). This is, without a doubt, an economic judgment. Yet it is one that economists seem incapable of accounting for because it makes no sense to them.
But, without becoming too dryly analytical, humans are not hardwired to think solely in terms of direct utility. Products can serve multiple functions; some direct, some indirect. Polo shirts, for example, have a direct function of keeping one’s upper body shielded from the elements. But certain polo shirts, such as those made by, say, Ralph Lauren, have an indirect function as a status symbol. And there are people in this world, apparently, who find the added, indirect value to be worth the cost. Economists have failed to account for this sort of thinking, and have thus neglected to consider the full range of value that decisions can provide, which is why there is such a divergence between reality and theory when it comes to things like Ultimatum Game.
The rest of the book, or at least the parts I read, seemed to bear this sort of thing out as well. Why is there such a difference between reality and theory in economics? The answer is, for the most part, quite simple: Economic theory doesn’t actually account for the behavior of real people.
Thaler, in making this decidedly simple point, feels compelled to dress it up in fancy mathematics. There is, of course, nothing inherently wrong with doing this, but it does make for a very dry read. Also, it seems to be a very complicated way of stating the obvious.
However, this degree of precision and insight makes the Winner’s Curse a necessary read for any aspiring economist. Economics, as a method of study, is not particularly useful if one neither knows nor corrects for the fundamental mistaken assumptions upon which the intellectual edifice is built. Economics does have plenty to offer, as a method of analysis, but it is only useful if its axioms are realistic. The Winner’s Curse, then, is useful because it questions the basics of theory. Not only that, it provides the answers as well.
By Winton Bates, on April 26th, 2011
 In his book, ‘Flourish’, Martin Seligman writes:
‘I am all for realism when there is a knowable reality out there that is not influenced by your expectations. When your expectations influence reality, realism sucks’ (p 236-7).
I have been thinking about the sentiments in that paragraph at various times over the last couple of days. My initial reaction was that it was wise as well as well written. The problem I now have with the passage is that in the context in which it is written it seems to imply that a realistic frame of mind is inconsistent with optimism. It seems to me that if we are realistic about the right things this can provide us with a stronger basis for optimism. (As an aside, the grammar check in Microsoft Word doesn’t agree with me that the passage was well written. It calls the second sentence a fragment and suggests that it be re-written. Robots have a tendency to be pedantic!)
I will give an example to explain why I think a realistic frame of mind can be optimistic and then consider the broad context in which the paragraph was written. A prime example of expectations influencing reality is in relation to our own behaviour e.g. in playing a sport. If you decide to be realistic about how you will respond to a given situation in future you might think that the most likely outcome is that you will perform in much the same way as you have in similar situations in the past. That might make tend to make you pessimistic about your prospects for improvement. Yet, when you think about it more deeply, a realistic frame of mind could enable you to make use of your inside knowledge of your own potential and your intentions in developing your expectations of your future performance. Your inside knowledge might thus provide you with a realistic basis for more optimistic expectations.
The context in which Seligman’s paragraph appears is in a discussion of the influence of expectations on capital markets and individual health outcomes. The evidence that he presents that expectations can influence individual health outcomes seems to me to be fairly strong. It may be worse that useless, however, for well-meaning people to use this knowledge to tell pessimists not to be so pessimistic. In my view if we want to help people we should give them plausible reasons for hope. My view on this are not be worth much, but Marty Seligman certainly doesn’t support happiness police urging people to fake positive emotion.
I can claim some professional knowledge about the effects of expectations on capital markets. Seligman’s comments on this topic were prompted by a claim by Barbara Ehrenreich that positive thinking destroyed the economy. According to her view, motivational gurus and executive coaches espousing positive thinking – using scientific props provided by academics like Martin Seligman – caused the recent global financial crisis and subsequent recession by infecting CEOs with viral optimism about economic prospects. Seligman responds that it is vacuous to suggest that the meltdown was caused by excessive optimism. Optimism causes markets to go up. Pessimism causes them to go down.
Ehrenreich is presumably suggesting that the bubble wouldn’t have burst if we didn’t have a bubble in the first place. Well, economists are still arguing about whether we did have an asset price bubble, and I don’t think many of those who think we had a bubble would lay the blame on positive psychology. In looking for the cause of the crisis we need to look for reasons why normally prudent financial institutions took on extraordinary risks. I don’t think it is necessary to look any further than the policies that central banks had pursued in the past that encouraged major financial institutions to believe that they were too big to be allowed to fail. The financial crisis occurred when the Fed decided to break with that policy and let one of the big gamblers go to the wall.
Seligman goes on to discuss asset pricing and the views of George Soros about reflexive reality. In my view he manages to make those views more comprehendible than Soros does. (My difficulty in understanding Soros was evident in this post.) According to Seligman, reality is reflexive if it ‘is influenced and sometimes even determined by expectations and perceptions’.
Economists have known for a long time that the market price of an asset is determined largely by expectations about future earnings from that asset and associated risks (reflected in discount rates). So, wealth can be considered to be a form of reflexive reality because it depends on expectations. As well as expectations about future earnings, the expectations that influence market prices at any time may include expectations that investors form about the optimism or pessimism of other investors – i.e. whether they are too optimistic or too pessimistic and how long they are likely to remain in that state.
From the perspective of the individual investor, however, the expectations of other investors are part of external reality that can be speculated about on the basis of their market behaviour, even though it isn’t knowable with any certainty. Her views about the expectations of other investors may influence her decisions to buy and sell, but her actions will have a negligible effect on market outcomes (unless she is a major player in the markets). Thus, even though asset values are determined by the combined expectations of investors, it doesn’t make sense for an individual investor to view her own expectations as influencing reality.
It seems to me that in personal investment, as in other aspects of life, it is good to have a realistic basis for optimism about the strategy one adopts. For example, consider the following advice that Warren Buffett offered retail investors. His basic message is optimistic: ‘Stocks are the things to own over time. Productivity will increase and stocks will increase with it’. Then he provides some realistic advice about how to avoid buying and selling at the wrong time and how to avoid paying high fees. This leads to even more realism: ‘Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market’. He ends up combining realism with optimism: ‘If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors’. (Comments by Warren Buffett in Spring 2008, quoted in Alice Schroeder, ‘The Snowball’, 2008, p 825.)
It is good to be optimistic, but even better to have a realistic basis for optimism.
………
My preceding post was also about Martin Seligman’s book, ‘Flourish’.
 Join the forum discussion on this post - (1) Posts
By Vipin Veetil, on February 6th, 2009
The eventful happenings of last year or so have not only unleashed a crisis on the world economy, but also unveiled what is probably an even greater problem – a crisis within economics itself! In the two decades or so before 2007, the primary proponent of anti-Keynesianism within the mainstream tradition was the Rational Expectations School (RES). Lucas, Prescott, Sargent et al, were the “best” macroeconomists, and their work is the staple diet of masters and PhD programs.
The basic idea behind RES is that “perfectly rational individuals” with “complete information” will react to government policies by adjusting their own behaviour, thus nullifying its impact. So for instance, if government increases its expenditure (fiscal stimulus), people will figure that taxes will go up in future since government is incurring a deficit which will have to be reduced later, so the net effect is 0.
There are of course various ways to contest the broad idea. But at the moment, policy makers have ignored the rational expectations guys on the simple grounds that their assumptions are entirely “unrealistic”. And this brings us to the bigger issue of what was the point of spending so much time and energy in deriving the results of RES, of teaching it around the world, if it is of no use when the we get an economic crisis. A compass is useful because it points to the north! Check out what RES has to say now here.
The Austrians have of course been doing much better. Within the Austrian Business Cycle Theory the present crisis originates from the low interest rate policy followed by Fed in the post dot com bust scenario. Natural rate of interest is the rate at which two individual will voluntarily be willing to lend and borrow from each other.
There is no such thing as “the” natural rate of interest, but many such rates. But let us for analytical ease assume there is one such rate, and its 5%. When a central bank (RBI did this too) fixes the rate at say 3%, we get two problems.
1. How to produce?
Entrepreneurs begin to investment in more long term production facilities, since the same quantity of monetary resources can now fund longer term projects. So I can begin building a factory which will take 10 years to complete and 10,000 tons of steel at 3% interest, but would have had to build a factory which takes 6 years to complete and uses 70,000 tons of steel at 5% interest. In other words, the time structure of production is artificially skewed.
2. What to produce?
Many goods which would have been unprofitable to produce at 5% interest, become profitable at 3%. In the very short term, low interest lowers cost of production but prices of final output remain the same. So we get goods which would not have been produced under natural conditions. At 3% households are saving less than at 5%, entrepreneurs are borrowing and investing more than at 5%. Less savings mean more consumption. More consumption and more investments pull the economy in opposing directions, we get inflation, central bankers panic, interest rates are hiked (remember the last months of the Y V Reddy regime), many projects become unfeasible because of rising cost, recession!
Note that since the cause of the crisis is misallocation of resources, we would like economy wide churning. Firms must readjust production processes, some firms will have to reduce employee count, these people will then be employed elsewhere (the time lag between the two registers a high rate of unemployment), some firms will have to shut down, other firms will have to produce new products (less luxury villas, more apartments for instance), and so on. And soon enough we will be back to a rather normal state of affairs.
Not understanding this process is the root cause of many dangerous proposals floating around in the press. Take A. K. Arun’s Economic Times article for instance, he says,“What is rational for individual enterprises could spell gross irrationality at the level of the economy. Job cuts at a large number of companies in the wake of the slowdown, is a good example of this phenomenon. As individual companies try to cut costs and reduce the impact on their bottom lines by laying off workers, the cumulative result is to depress demand for what all companies produce in the aggregate. This accelerates the slowdown, and releases further pressure to cut costs. There must be intervention at the macro level to stop this vicious cycle.”
Any government intervention will only further delay the process of economy wide churning which is the only way to recover with or without a fiscal stimulus. Arun proposes “a tax break for companies that do not lay off staff”, and says the tax break itself maybe a certain percentage of a firms “wage bill”. So we have an economy where there is been gross misallocation of resources, plenty of capital is been destroyed (10 year factories will have to be torn down, 6 year ones build), and instead of encouraging firms to become more efficient, employ least cost methods of producing goods so that there are more resources available for economy wide reconstruction, we encourage firm to increase wage bill, i.e. increase cost!
In fact what we really need is more savings, and it’s a good thing that household reduce consumption and increase savings during recessions, we need more resources to restructure production. But its not just Arun’s article really, the problem is with the whole of Keynesianism which is pretty much just the 20th century name for mercantilism!
|
|
Most Popular Posts