Monday, September 28, 2009

Kahneman on the financial crisis and behavioral economics

The present issue of Finance & Development profiles Daniel Kahneman, who was awarded the Nobel Prize in Economics in 2002 for pioneering work that focused on the integration of aspects of psychological research into economic science (which is now labeled as behavioral economics). Especially after the global financial crisis, this field of study has been more relevant now than ever. Behavioral economists have shown the limits of human cognition and busted the ideology that human beings are always rational agents. Behavioral economics challenged standard economic rational-choice theory and injected more realistic assumptions about human judgment and decision-making. He propounded “prospect theory”, which basically says that individuals often make divergent choices in situations that are substantially identical but framed in a different way.

Standard economic models assume that individuals will rationally try to maximize their benefits and minimize their costs. But, overturning some of the traditional tenets, behavioral economists show that people often make decisions based on guesses, emotion, intuition, and rules of thumb, rather than on cost-benefit analyses; that markets are plagued by herding behavior and groupthink; and that individual choices can frequently be affected by how prospective decisions are framed.

“One of the main ideas in behavioral economics that is borrowed from psychology is the prevalence of overconfidence. People do things they have no business doing because they believe they’ll be successful.” Kahneman calls this “delusional optimism.” Delusional optimism, he says, is one of the forces that drive capitalism.

“Entrepreneurs are people who take risks and, by and large, don’t know they are taking them,” he argues.In the United States, a third of small businesses fail within five years, but when you interview those people, they individually think they have between 80 percent and 100 percent chance of success. They just don’t know.”

He argues that there is a need for stronger protection for consumers and individuals; there is a need to look beyond the markets because failure of markets has much wider consequences; and there is always limits to forecasting because of tremendous volatility in the stock markets and financial systems (huge uncertainty).