Barry Schwartz | Decision-making and Economics - The Paradox of Choice | The European Magazine. Nudge thyself. Economists have more to learn from the natural sciences if they are to claim a realistic model of human behaviour You’ve come to a canteen for lunch: at one end of the counter, you see juicy fat burgers sizzling on a grill and, at the other end, healthy-looking salads. After a little hesitation, you choose the burger. “Cheese and bacon with that?” Well, why not? Classical economists, perhaps uniquely among members of the human race, would assume you made your decision fully aware of the implications of your actions, that you weighed up those implications and came to the conclusion that, all things considered, the cheese and bacon burger is the better choice.
Some economists have realised this and, given the failure of classical models to predict the financial crisis, their young discipline of behavioural economics is now enjoying something of a heyday. Take nudging. And this is just what the latest research is showing. Stephen Cave is a writer and philosopher based in Berlin. How We Were All Misled by John Lanchester. Boomerang: Travels in the New Third World by Michael Lewis Norton, 213 pp., $25.95 Most people with a special interest in the events of the credit crunch and the Great Recession that followed it have a private benchmark for the excesses that led up to the crash. These benchmarks are a rule of thumb, a rough measure of how far out of control things got; they are phenomena that at the time seemed normal but that in retrospect were a brightly flashing warning light.
“Well,” she said, “if I’m going to spend some time with friends at the weekend we go camping in the countryside.” “How is that different from what you did before?” “We used to take a plane to Milan and go shopping on the via Linate.” Since that conversation, I’ve privately graded transparently absurd pre-crunch phenomena on a scale from 0 to 10, with 0 being complete financial prudence, and 10 being a Reykjavik waitress thinking it normal to be able to afford weekend shopping trips to Milan. Lewis writes that. A wise man knows one thing – the limits of his knowledge. John Maynard Keynes, who never tried to conceal that he knew more than most people, also knew the limits to his knowledge. He wrote “about these matters – the prospect of a European war, the price of copper 20 years hence – there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” And Keynes was right. He published these observations in 1921, and 20 years later Britain was engaged in a desperate, and unpredictable, struggle with Germany.
But lesser men find prognostication easier. The models share a common approach. But little of this knowledge exists. This may lead to extravagant flights of fantasy. The impression of rationality these procedures convey is spurious. The future is assumed to be essentially like the present, with differences mainly derived from mechanical projection of current developments. Yet the mistaken belief persists that these procedures provide an objective basis for decision making. The Book of Jobs | Politics. What this transition meant, however, is that jobs and livelihoods on the farm were being destroyed. Because of accelerating productivity, output was increasing faster than demand, and prices fell sharply. It was this, more than anything else, that led to rapidly declining incomes.
Farmers then (like workers now) borrowed heavily to sustain living standards and production. Because neither the farmers nor their bankers anticipated the steepness of the price declines, a credit crunch quickly ensued. The cities weren’t spared—far from it. The value of assets (such as homes) often declines when incomes do. Given the magnitude of the decline in farm income, it’s no wonder that the New Deal itself could not bring the country out of crisis. The Agriculture Adjustment Act, F.D.R.’s farm program, which was designed to raise prices by cutting back on production, may have eased the situation somewhat, at the margins. Two conclusions can be drawn from this brief history. John Lanchester · The Art of Financial Disaster · LRB 15 December 2011. No essay in English has a better title than De Quincey’s ‘On Murder Considered as One of the Fine Arts’.
I wonder whether, if he were alive today, he might be tempted to go back to the well and write a follow-up, ‘On Financial Disaster Considered as One of the Fine Arts’? The basic material might be less immediately captivating, but there’s a lot to choose from. As Warren Buffett has pointed out more than once, ‘It’s only when the tide goes out that you learn who’s been swimming naked.’ Financial and economic downturns always cause a rash of scandals and exposure. The tide has gone out – it’s still going out – and, frankly, it’s hard to know where to look. In the UK, our most recent outrage has featured Northern Rock, the bank whose collapse in the autumn of 2007 was the first harbinger of the credit crunch and subsequent Great Recession.
The new news was the Rock’s sale to Virgin Money, for a price of £747 million. Many have tried to rival Goldman. The future: Expect the unexpected. Top economists reveal their graphs of 2011. Book Review: Why Nations Fail. The mathematical equation that caused the banks to crash | Science | The Observer. It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run.
It was like buying or selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments, blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream. Anyone who has followed the crisis will understand that the real economy of businesses and commodities is being upstaged by complicated financial instruments known as derivatives.
The equation itself wasn't the real problem. Black-Scholes underpinned massive economic growth. Black and Scholes invented their equation in 1973; Robert Merton supplied extra justification soon after. Black-Scholes implements Bachelier's vision.