Decision-making and Economics - The Paradox of Choice. 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. I came across mine in Iceland, talking to a waitress in a café in the summer of 2009, about eight months after the króna collapsed and the whole country effectively went bankrupt under the debts incurred by its overextended banks. “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.” The credit wasn’t just money, it was temptation. 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 Book of Jobs. 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.
Farmers simply couldn’t pay back what they owed. The cities weren’t spared—far from it. The value of assets (such as homes) often declines when incomes do. 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.
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. 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.