The Behavioural Economics of the Coalition’s Slump..

iposmrbiJust as all politics is, in the end, economics (what can we afford to do), it is reasonable to suggest that all economic policy is political (what can we afford to do). The name of this game is political economy after all, and we forget that at our peril. As we look forward to the last full year of the coalition, it is worth reflecting how things got to the state they are, languishing in the polls and by no means certain that they or any feasible coalition will be in power in 2016. 

Modern economics has begun to internalize the idea that people, the ultimate agents or economic actors, are psychologically complex. A look at some of the main elements of behavioral economics suggests that from that perspective the travails of the coalition were inevitable.

hqdefault (1)At the core of the governments puzzlement is this – having had 6 years of austerity budgets the last one was neutral, so why are people not hailing us? Worse, the economy is picking up (at least for some) so why should we, the coalition, be punished? This demonstrates a lack of understanding of how people read gains and losses. Its well demonstrated in the Monty Python skit where a group of Judean rebels discuss the romans, their leader asking “what have the romans ever done for us”. After a long list of public works, societal improvements etc they find one issue to hang them on. People do not feel the same about gains and losses of equal amounts. They feel the pain of loss much more than the joy of gains.  Having presided over a series of cutting budgets the pain of those vastly outweighs the joy of , as Leo Varadkar stated, a fiver a week in the pocket. This is compounded by what is known as a recency effect- we give disproportionally more weight to things that happened in the recent past than we do to things in the distant past. FF got hammered for their recent past of bankrupting the state and making us all look like goms. FG and Labour are now being punished for their recent past of reneging on election promises or “doing a Rabbitt” and more so for looking like incompetents when left on their own after the troika.

This recency effect is a manifestation of what is known as hyperbolic discounting. Not only do we disproportionally overweigh recent events in the past so also do we do for things that will happen in the future. Jam tomorrow is all very good, but jam in a few years time is more or less irrelevant. Promises that if we stick with the plan we will all be rich again in 2017 cut no ice to people looking at their flat prospects for 2015 and 2016.  In essence when it comes to economics individuals are short-term orientated. Institutions therefore need to counterbalance that. A classic example is the pesnions issue.  There is broad agreement that some form of supplement to the state pension is desirable and needed, and that the short-term nature of people when faced with long-term decisions requires auto enrollment into a pension. However, here we face the failure of Irish institutions head on.  Our political institutions are as short-term as ourselves, and there is no hope that such a policy, long-term beneficial but short-term painful, will happen with an election no more than 15mths away.

The Irish water omnishambles shows this recency bias, and also what is termed an endowment effect. People tend to overvalue what they have , and would require more to part with it than they would pay to get it. We now own ownership of Irish water, and a large part of the debate revolved around its possible privatization. There are rational arguments on what parts if any of a utility can and cannot be privatized. Generally, the delivery modes of pipes and networks are a natural monopoly and so less suitable for private ownership while a greater case can be made for production units such as power plants or water plants. Nonetheless, no effort was made by the political institutions to explain the costs and benefits of possible privatization, even if such was being ruled out.

Part of the coalition problem is one of success. They have steered the state out of the bailout programe, albeit following a strict road laid down for them. Things have stabilized and turned around. In economics and finance it is well known that success breeds not just or only success but also overconfidence. Successful traders tend to end up trading too much and eroding their profits. Overconfidence comes from a few sources. The government has shown biased self attribution, where our successes are down to our own efforts and the failures just unfortunate things that happen.  The government constantly note with pride how low bond yields are and how we can ow borrow again on the international markets, at times seeming to conflate that with the sole aim of the state. The reality is that this has nothing to do with us, and everything to do with first having been forced into a bailout and second the changed attitude (if not action) of the ECB. They suffer from confirmation bias, regularly stating “if we had not done X then…”, regardless of the possibility that without doing X something else, perhaps the same, perhaps worse, perhaps better, would have happened anyhow. Recall the decision to convert the prom notes to national debt, now being sold as a decision to save money, and the alternative of telling the ECB to like or lump a unilateral restructuring as having been wrong…. This is classic confirmation bias.  Its also an example of hindsight bias, where  like all of us the government benefits from 20-20 vision.

Knowing ones or ones clients biases is a basic first step in dealing with them from an asset management perspective. It should also be one for the state, and for its political components. Biases and heuristics are part of human nature. We need institutions that are strong enough to counterbalance them. Instead we get ones that ignore them, reinforce them, and play to them.

This is a version of a column published in the Irish Examiner 3 January 2015

2 thoughts on “The Behavioural Economics of the Coalition’s Slump..

  1. Pete

    I’m currently re-reading George Soros’s 1987 book “The Alchemy of Finance”, which is all about how standard economics models don’t work when dealing with thinking but irrational market participants who don’t have all the information (ie. humans). It sure has taken mainstream economics a long time to even start thinking along the same lines.

  2. Pingback: Cognitive biases and Election 2016 | Brian M. Lucey

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