Behavioural Economics and the recession

This is a version of an opinion piece in the Irish Examiner 9 March 2013

One of the features of the recession, or depression or whatever it is we are going through is that the role of economists and economics has become more in focus. Seen from the inside however what is stark is how lopsided this has been and how this throws up some questions on policy formation. Much of the economic talk has, perhaps perforce, been dominated by discussions on macroeconomic and macrofinancial issues with real estate economics coming close on their heels.  This is all very exciting stuff but suggests to the lay listener or reader that that is what economics is all about – budget deficits, banking balance sheets, house price dynamics and bubble analytics. The reality is of course massively different; economics is first and foremost about the relative cost and benefit of choices. Different actors make different sets of choices ; firms about employment and production, workers about work and leisure, consumers about goods and services and so on.  And people make decisions based on a combination of rational and other reasons.  economists work in areas around health, education, financial decision making, trade, family issues, anywhere that there are costs and benefits.

Recently, say in the last ten years or so, behavioural aspects have begun to reenter into the core of (most) economic models.  In part this “respectability” reflects and is reflected in the awarding of the 2003 Nobel to Daniel Khaneman and Amos Tversky. Again it may seem strange but for much of the last 50 years the rational calculation of tradeoffs was THE only way to model much of economics, only in the sense of being accepted by the academy.  Despite the seminal work of Keynes, and others, on “animal spirits”, man as a social and psychologically complex animal disappeared from the economic model to be replaced by a bloodless calculator. The last decade has seen this challenged. Models and policy now, with the glaring exception of “high macro” are comfortable with incorporating into their model the notion that people matter in terms of how they decide their choices and that these choices are not always a cold rational decision. What is rather startling however is how relatively little these behavioural approaches are evident in the media debate, which perhaps reflects the relative paucity of related researchers in this area in Ireland. Few economists or finance researchers take a behavioural approach and most of those are in the areas of health, education and related. Some of the very best have left, unable to progress in their careers and so benefit the (in particular) Australian and Scottish academic and policy formulation scene to the detriment of here. So what can behavioural approaches tell us about recent events?

One of the main planks of this approach is that of loss aversion, arising from the Khaneman and Tverskey refined Prospect theory. This in essence says that we feel the pain of a given loss far more than we feel the gain of the same amount won. Consider the imposition of the household and house taxes. The amounts are small but the pain large. Similarly with the changes in the child benefit. It has relatively little to do with people being unable to pay (although some will be in such position) and everything to do with deep human nature. Thus there is little point in government trying to sugar that pill. It wont be swallowed easily. Expecting people to be rational about losing money is futile.

A further major plank is what is called hyperbolic discounting. Recall the recent discussion of the “win” in the restructuring of the promissory notes ; much of the putative gain emerges from delaying any repayments, in the knowledge that from todays perspective a billion euro in twenty years time is seen as much less than a billion. That time value of money approach simply however is not how people see things.  More realistic discounting would suggest that the value of that billion (for reasonable interest rates) is still “less” than a billion but is significantly greater than the traditional time value of money would suggest.  Thus those that sell the time value of money approach to the notes are , willfully or not, ignoring the deep preferences of people. Worse, they missell to themselves and to others the real benefits, over egging the pudding whether they know it or not.

Beyond this we find in behavioural economics that we need to understand the biases and shortcuts (heuristics in the jargon) that people take when faced with decisions under (especially monetary related) choices. For example we tend, as people, to anchor prices and wages and other monetary amounts to recent levels regardless of what “fundamentals” tell us. This is part of the explanation for the growth of bubbles : its not that people are feckless or greedy just that they are people and they look back over a short horizon and anchor expectations at recentl levels.  Decrying the unrealistic nature of these expectations is fine but calumnising people for being people is both futile and dangerous.  Anchoring is everywhere …And then when we cut wages (such as say in the public sector) this combines with the loss aversion to cause deep disquiet, over and above the “warranted” levels of disquiet.

We tend to disregard evidence from the past over evidence from the more recent times, and we engage in what is called “base rate neglect”, wherein we in effect assign events to representative categories. A deeper analysis of this involves Bayes Rule, and most people are not intuitive bayesians… Thus we find statements that “this time is different”, based on the last five years and the fact that full information about the past 50 years is not being used. There is a danger that we assume for example that there will be a neverending recession – there wont. This too shall pass, and we will eventually have another credit or related bubble and shall make similar mistakes. Finally, consider overconfidence, something we seem to have little of at present. Overconfidence is again something we have hardwired. But it is more prevelant in men than in women and success breeds not just confidence but overconfidence. Then look at the ECB – hard though it may seem to us here they have had success, in that they have kept the euro together, dampened the fires of speculation, reduced bond yields and kept inflation low. These are pretty much all it has been tasked to do. So, the male dominated ECB must be feeling confident, and the longer the run of success goes on the more overconfidence will be bred. Overconfidence breeds  failure. We must therefore be prepared for the inevitable crisis that will happen when the overconfident ECB, sometime in the next decade, drops the ball. With our luck that will happen just as the next bubble pops, but then we are human after all, even the members of the executive board of the ECB!

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4 thoughts on “Behavioural Economics and the recession

  1. Roger O Keeffe

    Probably an accident of nationality rather than sex, but the ECB under Christine Lagarde currently seems much closer to the real world than the testostero-selfdestructive ECB.

    Reply

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