Tuesday, August 11, 2009

Crazy Economics: What Do Me and Alan Greenspan Have in Common?

Let’s review the evidence:

In late October last year, former Fed Chairman Alan Greenspan told Congress that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Last week, I entered an ATT&T store with the sole purpose of updating my plain vanilla account. I left with an iPhone. I am in a state of shocked disbelief.

Classical economics holds that, when it comes to money, individuals and markets make rational decisions. Ha!

Okay, what is going on? An article by Gary Stix in the July Scientific American offers some insight. In the wake of the worst financial meltdown since the Great Depression, classical economic dogma is being exposed to serious scrutiny. In the meantime, behavioral economics is getting a second look.

Classical theory makes sense when markets are in a state of relative equilibrium. Like the brain or the environment, the economy is a nonlinear self-regulating system with its own internal logic. Even when things go wrong, the invisible hand of the market place has an uncanny way of setting things right.

Indeed, classical economics would work perfectly if only people weren’t involved. Unfortunately, classical economics can’t account for stupid human tricks. And sometimes when things go wrong, markets fail to self-correct.

Enter behavioral economics. According to Scientific American:

“Emotion-driven decision making complements cognitive biases - money illusion’s failure to account for inflation, for instance - that lead to poor investment logic.”

In one experiment, subjects made financial deals as their brains were being scanned. When presented with a result that only looked like a gain if you didn't think things all the way through, the ventromedial prefrontal cortex (VMPFC) lit up. The VMPFC is wired into risk and reward, as are the more primitive nucleus acumbens and amygdala, which mediate greed and fear, respectively.

In other words, high emotion and faulty cognition have always been a recipe for disaster, whether in choosing a mate or making an investment. Some of the cognitive biases we are prone to include overconfidence (we all think we’re better than average), herding (tendency to follow crowds), and availability (giving undue weight to recent events).

Scientific American quotes Andrew Lo of MIT: “Economists suffer from a deep psychological disorder that I call ‘physics envy.’ We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws laws that capture 3 percent of behavior.”

And there we have it.

What was going on in Alan Greenspan’s mind when he thought that markets could self-regulate forever? What was going on in my mind when I bought an iPhone?


Anonymous said...

You both read "Atlas Shrugged", and 'The Fountainhead".

Was it an iphone or an iphone G3?

Elizabeth said...

Yes, well, mathematics and mysticism have been intertwined since the pre-Socratics. The belief that economists can predict the future and comprehend human behavior through rationality is characteristic of the times: the scientific era. As you know, I call it Laputa land.

We both share past careers in economics. The company I worked for is The Freedonia Group. Every once in a while a customer would enquire about the name. Shouldn't it be spelled Fredonia, as in Fredonia, NY?, they'd ask, perplexed. Truth be told, the owner named it after the land of Freedonia from duck Soup, you know, the Marx Brothers' movie.

John McManamy said...

Hey, Elizabeth. Laputa Land - the scientific dystopia in Gulliver's Travels. But at least science has a self-correcting mechanism - propositions are exposed to brutal peer scrutiny and even entrenched dogma is open to challenge.

This kind of self-correction does not exist in religion or in political-social-economic movements founded on pure dogma.

I recognized the name, Freedonia, right off. Duck Soup, the famous mirror scene, the best comic scene ever. Recall the famous line, Chico to Groucho: "Who are you going to believe, me or your own eyes." Mirrors and illusions - what a brilliant inspiration for the name of your consulting group. :)

Elizabeth said...

Yeah, well, Bill Weiss, The Freedonia Group's founder, was smart and funny. Figured out early that the feds have little handle on tracking the markets, so figured, what the hell. Made a nice business on selling economic predictions. Kept a crystal ball on his otherwise messy desk. Didn't fire me even after I called him an asshole in hearing range of 30 or so employees-yet I must say, after years of reflection, he did deserve it. I was seriously manic. But then, he was seriously an asshole. Tit for that and this for that and let's just watch another Marx Brothers' movie.

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