Encefalus

The readers of Encefalus probably remember this article: A different view on economics: maybe all we really need.

I found this article recently in the New York Times: The Behavioral Revolution. It is an article that expresses some views similar to the ones we expressed in A different view on economics: maybe all we really need, indicating how psychology can help economists explain the recent credit crunch (for the recent economic crisis see here: Financial crisis of 2007–2008). The publishing of such an article in a newspaper the size of New York Times, clearly shows that here we have an underlying new trend in economics and psychology that breaks the disciplinary boundaries.

David Brooks, the author of the article, makes some very interesting points based on a basic premise: people are irrational.

However, I am always amazed by the chasms that exist betweent the various disciplinary fields. If people were truly rational , as economists, believe, then psychology would have no place as a science. We would study instead formal logic. The study of psychology is nothing more than the study of the laws that define human behavior. And if people acted based on logic alone, then psychology would have reached its final conclusions a long time ago.

Of course, there is always another view on the subject of rationality. Sure, people are irrational, but we can make two exceptions

1)People act rationally in times of danger, like the recent crisis

2)Through the Law of Large Numbers and the Central Limit Theorem, the noise inherent to the system that is constituted by the interactions of irrational economic agents, is stabilized, resulting to a kind of symmetry that approaches the normal distribution curve and can be analysed by the current mathematical models that the neoclassical economics (the main trend in economics) use.

The first argument can be summarized and refuted by a few words from The Behavioral Revolution article

Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest.

But during this financial crisis, that way of thinking has failed spectacularly. As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

In addition to this statement by Alan Greenspan, I have a very good blog to show you, concerning the first argument: Predictably Irrational. It is a blog by the author of the book Predictably Irrational, Dan Ariely from where I found the above link the the NY Times article. As its name clearly implies, it deals exactly with that subject, the irrationality of the human being. There you’ll find many tiny pieces of the grand puzzle of irrationality that works wonders into our heads, making us taking decisions, while at the same time the true reasons of our decisions remain obscure. These ought to convince you over this fact.

Another case of irrationality…

Of course, Encefalus has written many articles on this subject before, since the deconstruction of the hyper-bolstered ego of the human race, is an activity I am really fond of . You can read these articles for more information: Lotteries, poverty and social implications, Lotteries, poverty AND credit cards this time along with the proper social and scientific analysis , Subliminal messaging, subliminal advertising and subliminal learning for a subliminal post , The cookie effect

The second argument posed can be said to be the standard choice for the mathematics that concern many fields of the social sciences. The modern portfolio theory of economics is based on the premise that the system follows the normal distribution curve.

Now, concerning the second argument, we should take a look back at the article A different view on economics: maybe all we really need, where I mention the french mathematician Benoit Mandelbrot.

Benoit Mandelbrot

I copy from the original article 

[...]On the other hand, we got the second view we mentioned above, that we need new math. This view has been expressed in many articles in Scientific American. The oldest (I think) and, probably, the most important is this: How Fractals Can Explain What’s Wrong with Wall Street written by Benoit B. Mandelbrot himself, the mathematician who discovered the famous Mandelbrot Set. 

In this article he discusses how portfolio theory has been based on the wrong assumptions (like the normal distribution curve) and therefore, provides wrong results. He proposed the use of fractal geometry instead, which can explain extreme events. In portfolio theory extreme changes are considered unlikely and, therefore, not worth mentioning. In fractal analysis, extreme events are considered a part of the system.

So, the second argument is false as well.

David Brooks mentions many researchers that have explored the field of irrationality

Economists and psychologists have been exploring our perceptual biases for four decades now, with the work of Amos Tversky and Daniel Kahneman, and also with work by people like Richard Thaler, Robert Shiller, John Bargh and Dan Ariely. 

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Nassim Nicholas Taleb has been deeply influenced by this stream of research. Taleb not only has an explanation for what’s happening, he saw it coming. His popular books “Fooled by Randomness” and “The Black Swan” were broadsides at the risk-management models used in the financial world and beyond.

In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.”

Nassim Taleb

Then the article continues by elaborating on the work of Taleb

In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.”

Taleb believes that our brains evolved to suit a world much simpler than the one we now face. His writing is idiosyncratic, but he does touch on many of the perceptual biases that distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck.

The article also includes Taleb’s interpretation of the recent crisis

And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters.

Taleb is characteristically vituperative about the quantitative risk models, which try to model something that defies modelization. He subscribes to what he calls the tragic vision of humankind, which “believes in the existence of inherent limitations and flaws in the way we think and act and requires an acknowledgement of this fact as a basis for any individual and collective action.” If recent events don’t underline this worldview, nothing will.

I

In wikipedia, you can find some more clarifications 

In 2006, in The Black Swan

Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events "unlikely".

And then the article, closes with a final observation

This meltdown is not just a financial event, but also a cultural one. It’s a big, whopping reminder that the human mind is continually trying to perceive things that aren’t true, and not perceiving them takes enormous effort.

This is exactly what I am trying to talk about in this blog. Every social science has social implications. The utter idiocy and megalomania of business executives led to a global crisis. In Dangerous Ideas: Information and cultural revolution in the age of the internet or metacognition in the modern society and in Neurons, politics and economics we mentioned Steven Pinker’s view that only through knowledge society can progress. And true knowledge requires the exploration of ideas that are considered, dangerous, revolutionary or even heretical. Maybe we should start to look into the idea of our own irrationality, lest we avoid another catastrophe.

This entry was posted on Saturday, November 1st, 2008 at 6:42 pm and is filed under Economics, Socio-Political. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.