Behavioral Economics and Complexity
Contemporary behavioral economics has its roots in mid-twentieth-century social science. Pioneering sociologists such as Stanley Milgram and Robert K. Merton conducted wide-ranging experiments and analyzed data to develop new insights into human behavior.
Robert K. Merton’s most famous contribution was the formalization of the idea of the self-fulfilling prophecy. The idea is that a statement given as true, even if initially false, can become true if the statement itself changes behavior in such a way as to validate the false premise. Intriguingly, to make his point Merton used the example of a run on the bank in the days before deposit insurance. A bank can begin the day on a sound basis with ample capital. A rumor that the bank is unsound, although false, can start a stampede of depositors trying to get their money out all at once. Even the best banks do not maintain 100 percent cash on hand, so a true bank run can force the bank to close its doors in the face of depositor demands. The bank fails by the end of the day, thus validating the rumor even though the rumor started out as false. The interaction of the rumor, the resulting behavior and the ultimate bank failure is an illustration of a positive feedback loop between information and behavior.
Merton and other leading sociologists of their time were not economists. Yet in a sense they were, because economics is ultimately the study of human decision making with regard to goods in conditions of scarcity. The sociologists cast a bright light on these decision-making processes. Former Bear Stearns CEO Alan Schwartz can attest to the power of Merton’s self- fulfilling prophecy. On March 12, 2008, Schwartz told CNBC, “We don’t see any pressure on our liquidity, let alone a liquidity crisis.” Forty-eight hours later Bear Stearns was headed to bankruptcy after frightened Wall Street banks withdrew billions of dollars of credit lines. For Bear Stearns, this was a real-life version of Merton’s thought experiment.
A breakthrough in the impact of social psychology on economics came with the work of Daniel Kahneman, Amos Tversky, Paul Slovic and others in a series of experiments conducted in the 1950s and 1960s. In the most famous set of experiments, Kahneman and Tversky showed that subjects, given the choice between two monetary outcomes, would select the one with the greater certainty of being received even though it did not have the highest expected return. A typical version of this is to offer a subject the prospect of winning money structured as a choice between: A) $4,000 with an 80 percent probability of winning, or B) $3,000 with a 100 percent probability of winning. For supporters of efficient market theory, this is a trivial problem. Winning $4,000 with a probability of 80 percent has an expected value of $3,200 (or $4,000 × .80). Since $3,200 is greater than the alternative choice of $3,000, a rational wealth-maximizing actor would chose A. Yet in one version of this, 80 percent of the participants chose B. Clearly the participants had a preference for the “sure thing” even if its theoretical value was lower. In some ways, this is just a formal statistical version of the old saying “A bird in the hand is worth two in the bush.” Yet the results were revolutionary—a direct assault on the cornerstone of financial economics.
Through a series of other elegantly designed and deceptively simple experiments, Kahneman and his colleagues showed that subjects had a clear preference for certain choices based on how they were presented, even though an alternative choice would produce exactly the same result. These experiments introduced an entirely new vocabulary to economics, including certainty (the desire to avoid losses, also called risk aversion), anchoring (the undue influence of early results in a series), isolation (undue weight on unique characteristics versus shared characteristics), framing (undue weight on how things are presented versus the actual substance) and heuristics (rules of thumb). The entire body of work was offered under the title “prospect theory,” which marked a powerful critique of the utility theory used by financial economists.
Unfortunately, behavioral economics has been embraced by policy makers to manipulate rather than illuminate behavior based on dubious premises about their superior wisdom. Bernanke’s campaign to raise inflationary “expectations” by printing money and devaluing the dollar while holding rates low is the boldest contemporary version of such manipulation, yet there are others. Orchestrated propaganda campaigns have involved off-the-record meetings of corporate CEOs with business reporters requesting that they apply a more favorable spin to business news. These attempted manipulations have their absurd side, as with the phrase “green shoots” repeated ad nauseam by cable TV cheerleaders in the spring of 2009 at a time when America was losing millions of jobs. Tim Geithner’s self-proclaimed “Recovery Summer” in 2010 is another example—that summer came and went with no recovery at all for the forty-four million on food stamps. These are all examples of what Kahneman called “framing” an issue to tilt the odds in favor of a certain result.
What Bernanke, Geithner and like-minded behavioralists in policy positions fail to see is something Merton might have easily grasped—the positive feedback effect that arises from framing without substance. If the economy is actually doing well, the message requires no framing and the facts will speak for themselves, albeit with a lag. Conversely, when reality consists of collapsing currencies, failed banks and insolvent sovereigns, talk about green shoots has at best a limited and temporary effect. The longer- term effect is a complete loss of trust by the public. Once the framing card has been played enough times without results, citizens will reflexively disbelieve everything officials say on the subject of economic growth even to the point of remaining cautious if things actually do improve. This does not represent a failure of behavioral economics so much as its misuse by policy makers.
Behavioral economics possesses powerful tools and can offer superb insights despite occasional misuse. It is at its best when used to answer questions rather than force results. Exploration of the paradox of Keynesianism is one possibly fruitful area of behavioral economic research with potential to mitigate the currency wars. Keynesianism was proposed in part to overcome the paradox of thrift. Keynes pointed out that in times of economic distress an individual may respond by reducing spending and increasing savings. However, if everyone does the same thing, distress becomes even worse because aggregate demand is destroyed, which can cause businesses to close and unemployment to rise. Keynesian-style government spending was thought to replace this shortage of private spending. Today government spending has grown so large and sovereign debt burdens so great that citizens rightly expect that some combination of inflation, higher taxation and default will be required to reconcile the debt burden with the means available to pay it. Government spending, far from stimulating more spending, actually makes the debt burden worse and may increase this private propensity to save. Here is a conundrum that behavioral economists seem well suited to explore. The result may be the discovery that short-term government austerity brightens long-run economic prospects by increasing confidence and the propensity to spend.
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