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).

Noam Chomsky on crisis and hope

A very interesting and provocative article by Noam Chomsky:

As the fate of Bangladesh illustrates, the terrible food crisis is not just a result of “lack of true concern” in the centers of wealth and power. In large part it results from very definite concerns of global managers: for their own welfare. It is always well to keep in mind Adam Smith’s astute observation about policy formation in England. He recognized that the “principal architects” of policy—in his day the “merchants and manufacturers”—made sure that their own interests had “been most peculiarly attended to” however “grievous” the effect on others, including the people of England and, far more so, those who were subjected to “the savage injustice of the Europeans,” particularly in conquered India, Smith’s own prime concern in the domains of European conquest.

The distribution of concerns illustrates another crisis, a cultural crisis: the tendency to focus on short-term parochial gains, a core element of our socioeconomic institutions and their ideological support system. One illustration is the array of perverse incentives devised for corporate managers to enrich themselves, however grievous the impact on others—for example, the “too big to fail” insurance policies provided by the unwitting public.

There are also deeper problems inherent in market inefficiencies. One of these, now belatedly recognized to be among the roots of the financial crisis, is the under-pricing of systemic risk: if you and I make a transaction, we factor in the cost to us, but not to others.

The architects of Bretton Woods, John Maynard Keynes and Harry Dexter White, anticipated that its core principles—including capital controls and regulated currencies—would lead to rapid and relatively balanced economic growth and would also free governments to institute the social democratic programs that had very strong public support. Mostly, they were vindicated on both counts. Many economists call the years that followed, until the 1970s, the “golden age of capitalism.”

The “golden age” saw not only unprecedented and relatively egalitarian growth, but also the introduction of welfare-state measures. As Keynes and White were aware, free capital movement and speculation inhibit those options. To quote from the professional literature, free flow of capital creates a “virtual senate” of lenders and investors who carry out a “moment-by-moment referendum” on government policies, and if they find them irrational—that is, designed to help people, not profits—they vote against them by capital flight, attacks on currency, and other means. Democratic governments therefore have a “dual constituency”: the population, and the virtual senate, who typically prevail.

The synergy of running corporations and controlling politics, including the marketing of candidates as commodities, offers great prospects for the future management of democracy.

One of the reasons for the radical difference in development between Latin America and East Asia in the last half century is that Latin America did not control capital flight, which often approached the level of its crushing debt and has regularly been wielded as a weapon against the threat of democracy and social reform. In contrast, during South Korea’s remarkable growth period, capital flight was not only banned, but could bring the death penalty.

Where neoliberal rules have been observed since the ’70s, economic performance has generally deteriorated and social democratic programs have substantially weakened.

The phrase “golden age of capitalism” might itself be challenged. The period can more accurately be called “state capitalism.” The state sector was, and remains, a primary factor in development and innovation through a variety of measures, among them research and development, procurement, subsidy, and bailouts. In the U.S. version, these policies operated mainly under a Pentagon cover as long as the cutting edge of the advanced economy was electronics-based.

The crucial state role in economic development should be kept in mind when we hear dire warnings about government intervention in the financial system after private management has once again driven it to crisis, this time, an unusually severe crisis, and one that harms the rich, not just the poor, so it merits special concern.

Selective application of economic principles—orthodox economics forced on the colonies while violated at will by those free to do so—is a basic factor in the creation of the sharp North-South divide.

People cannot be told that the advanced economy relies heavily on their risk-taking, while eventual profit is privatized, and ‘eventual’ can be a long time.

There was a dramatic increase in the state role after World War II, particularly in the United States, where a good part of the advanced economy developed in this framework.

Returning to what the West sees as “the crisis”—the financial crisis—it will presumably be patched up somehow, while leaving the institutions that created it pretty much in place.

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here