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March 1, 2009

WHAT WERE WE THINKING?

This issue, a look at some classics and at a whole new field.

READING LIST
A Short History of Financial Euphoria by John Kenneth Galbraith, Penguin Group, 1990.
The General Theory of Employment, Interest, and Money by John Maynard Keynes, first published 1936.
How We Decide by Jonah Lehrer, Houghton Mifflin Co., 2009. An extremely readable book about what neuroscience tells us about decision-making, from the 27-year-old wunderkind, former Rhodes Scholar and author of the blog The Frontal Cortex, http:// scienceblogs.com/cortex.
Making Up the Mind: How the Brain Creates Our Mental World by Chris Frith, John Wiley & Sons, 2007. About how we perceive the physical world: Is that really blue, or does my brain just tell me it’s blue?
Neuroeconomics: Decision Making and the Brain, edited by Paul W. Glimcher, Colin F. Camerer, Ernst Fehr, Russell A. Poldrack, Elsevier, 2009. Research papers into all aspects of neuroeconomics.
Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely, HarperCollins, 2008.

The current economy is one of those times when you thump your forehead, call yourself an idiot aloud and chastise yourself for missed opportunities or not having enough prescience to get out while the getting was good. I give myself credit for correctly reading the real estate investment market in time to head home with my little bag of profits. I kick myself for not buying a house in Provence, France, when I wanted one because by now it would be paid for and, also by now, I can’t afford one. And I am very grateful that I did not retire early and move to Provence when my portfolio seemed to double in value overnight and it looked like I would never work again while watching the grapes grow because, if I had, with the current state of my portfolio, I would now be a grape picker—assuming they’re hiring.

Why do we do this? Why do we buy what we buy and plan what we plan? Why do we put faith in financial and economic systems that have proven time and again to be flawed and subject to fairly predictable swings from up to down and back? Why, when we watch yet another financial genius led off in handcuffs leaving a trail of weeping investors who have lost everything, do we not remember the financial genius who preceded him?

To find out—and for comfort that I am not the only idiot in the world—I turned to some economic classics and leaders in the new field of neuroeconomics, the study of how our brains determine our economic behavior. (See Reading List below)

You Are Not a Rational Being

Dan Ariely, one of the leading authorities on behavioral economics (aka neuroeconomics), can tell you why you do what you do, especially where financial decisions are concerned. The fact that we are irrational and, more depressing, predictably so, seems not to bother him at all. But perhaps that’s what you get from someone who founded the Center for Advanced Hindsight.

Ariely, now a professor at Duke University, has conducted all manner of empirical research using everything from beer to loud noises to prove that we have little control over our own financial decisions. The results are pretty amazing.

If we are offered three things, we will buy the mid-priced one, regardless of real value. If we move from a high-cost city to a low-cost city, we don’t buy a comparable house for less, we buy a bigger house. We will buy something just to be different whether we like it, want it, need it or even use it. And we will always, always, always go for something that’s free. We overvalue what we have, we can’t make ourselves do what we want and we deal in credit even when dealing in cash makes us more frugal.

We continue to do these stupid things and repeat them over and over “because of the basic wiring of our brains,” Ariely finds. We have choices, of course, and the wherewithal to exercise them, but we choose in predictable ways; ways that the more manipulative parts of the economy have learned to exploit. We are, therefore, not the problem. Standard economic theory is.

Standard economic theory is based on what we should do, not what we really do. Take the law of supply and demand. Wrong, Ariely says. Our willingness to pay a price for something is actually determined by “arbitrary coherence.” The initial price of anything is arbitrary. Black pearls had no value until gemstone dealer Harry Winston set them in his Manhattan show window in 1974 among the diamonds and emeralds, and now they are “worth” just as much.

The accepted price of anything becomes its “anchor.” When gasoline prices spiked last year, it was not a function of scarcity. Although initially “flabbergasted” at the higher prices and temporarily flirting with mass transit, Americans simply adjusted their anchor—their idea of what gas was worth—and paid the price. Now that prices have come back down, gas seems cheap. What it’s really worth—influenced by perception, what the market will bear, and supply and demand—is anyone’s guess.

You Are Not Even a Sane Being

In 1990, the famous economist, former U.S. ambassador to India, Harvard professor, adviser to presidents and author of such landmark books as The Great Crash 1929, John Kenneth Galbraith, wrote a long essay. Throughout his career, he followed the phenomenon of “recurrent speculative insanity and the associated financial deprivation and larger devastation” that inevitably follows. What he found is distilled into a slender book that shows what episodes ranging from the Dutch tulip mania of the 17th century to the savings-and-loan debacle of the early 1990s have in common.

Galbraith was all too aware that there are simple, well-reasoned, logical lessons here that we fail to learn. Ariely’s hope that “once you see how systematic certain mistakes are—how we repeat them again and again—I think you will begin to learn how to avoid some of them” is so much wishful thinking, Galbraith writes. Our collective memory of the most recent financial euphoria and its demise has an outside limit of 20 years, he says. The Great Depression still lingers in that generation’s memory, but it hasn’t stopped them or their children from falling for the latest iteration of the “secret” to sustained wealth and uninterrupted economic growth.

To be as brief and clear as Galbraith, here are his findings.

  • Participants in economic euphoria have two basic beliefs: First, there is a new reality, one that means that the market will go up and stay up, perhaps indefinitely.Second, those who recognize the boom as speculative are sure they can profit but get out in time.There are also two common denominators to all financial booms:
    • One is “the extreme brevity of the financial memory.… There can be few fields of human endeavor in which history counts for so little as in the world of finance,” Galbraith writes.
    • The second is “the specious association of money and intelligence.” Bernard Madoff is not a new phenomenon. Remember junk bond king Michael Milken, or John Law, who in the early 1700s said he could pay off France’s debts with nonexistent gold from Louisiana?
  • Finally and most startling, there is no such thing as innovation in financial operations. “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” Every crisis involves debt that is “dangerously out of scale in relation to the underlying means of payment.” Think of the corporate bonds of the 1980s and the collateralized debt and sub-prime mortgages of today.

Why, Galbraith wonders, are we so fascinated by such train wrecks, especially if we refuse to draw the obvious conclusion and not fall for the latest house of financial cards? “One relishes,” he writes, “especially if from afar, the drama of mass insanity.” We are not, however, “afar” at this point, so how long might this sorry situation last, and what’s to be done about it?

The Turn Around

The last time I had to read John Maynard Keynes, I was in graduate school. There was a good bit riding on my understanding him insofar as I needed the grade, but as an impoverished grad student, I had no real skin in the game. I had no skin in any game. Now that, thanks to Ariely, I’ve discovered I’m neurologically wired to make bad financial decisions and, thanks to Galbraith, it is impossible to learn from my mistakes, I decided to revisit the master to find out how long I will have to pay for my foolishness.

Keynes’s most famous book, The General Theory of Employment, Interest, and Money, is, in the words of former Labor Secretary Robert Reich, “convoluted, badly organized and in places nearly incomprehensible.” This is a comfort as there is much of it I didn’t understand the first time around and still don’t. The book was written in 1936 at the height of the Great Depression, and Keynes’s aim was to figure out how economics could foster universal employment. We now know that there can be no such thing as zero unemployment, but the revolutionary part of his theory did, in fact, probably save capitalism at a time when socialism looked all too attractive.

The General Theory spends a lot of time discussing interest rates, which, to my mind, is what got us into this mess. Keynes says “the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it.” If money is easy to get—i.e., banks will lend it readily— there is no reason to hold onto it, so we spend it, we invest it, we save it (in return for interest). Other than as a “store of wealth” or a “store of value,” money needs to move; there is no reason to hold it. If, as now, banks themselves are uncertain about the future, they are unwilling to part with their control over liquidity. In a chilling echo of the era in which the book was written, Keynes mentions a crisis in the United States, “a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.”

This is why he argued for—get ready for it—government bailouts. When consumers and businesses won’t spend money and banks won’t lend it, the only possible remedy is for the government to spend and invest. This is what brought President Franklin D. Roosevelt to adopt the ideas of a man he thought of more as a mathematician than an economist. If it hadn’t worked then, Keynes might not be so revered.

Much of the criticism, then as now, centers on supposed socialistic tendency. Keynes did not see his theory as socialism but as a new, innovative form of capitalism, more enlightened and more sustainable. There were circumstances that called for deficit spending. There were reasons to narrow the gap between rich and poor. There were ways to manufacture free markets and make them work. Economics was, in his view, more powerful than politics.

Can We Do the Right Thing?

This recession, as with all those in the past, seems a giant Gordian knot that only the smartest people can unravel. Given that we have so little confidence in those in charge, however, is there any reason to hope that the recovery will be swift, simple or sustainable, or that, in fact, we’re doing the right things to solve this one and prevent future ones?

The gurus, past and present, are pretty unanimous in their findings. Without the benefit of neuroeconomic findings, Galbraith realized that much of the problem is human frailty. What we need is “an enhanced sense of skepticism,” but our skepticism is always short-lived because, to quote Galbraith quoting Walter Bagehot, editor of The Economist in the mid-1800s, “All people are most credulous when they are most happy.”

Standard economic theory, the basis of the whole system, is flawed. It was flawed in Keynes’s day because it promoted vast inequities that, in the end, made the economy unsustainable. It is flawed today because, Ariely says, it is not “based on how people actually behave, [but on] how they should behave.” The Great Depression gave rise to Keynes and a new way of organizing an economy; perhaps neuroeconomics can show us a new way forward this time.

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,” Keynes writes. “Indeed the world is ruled by little else.”

A world ruled by ideas sounds the best advice of all. But that will not be swift. Keynes’s book came out in the mid-1930s, and the Depression lasted until the end of that decade, or until Japan bombed Pearl Harbor. Another war is hardly what we need now, so we will have to rely on the Obama administration’s stimulus package and the launch of the sort of personal options that Ariely posits to keep our own frailties in check.

The fact is, the world is not ruled by ideas. Instead, in some other immortal words from the 1930s, these from the roller coaster crash of the Weimar Republic: “Money makes the world go around,” sings the Emcee at Berlin’s Kit Kat Klub. “The clinking, clanking sound of money, money, money…”