The latest global financial and economic crisis has highlighted the inadequacy of traditional economic theory to explain people’s and markets’ economic behavior. The increasing momentum of behavioral economics rooted in history and psychology may provide an explanation of why people and markets behave irrationally. In this essay I place behavioral economics into a historical context of economic thinking and explore the nature and impact of common biases that can distort decision-making.

Introduction

The outstanding fact is the extreme precariousness of the bases of knowledge on which our estimates of prospective yield have to be made. Our knowledge of factors which govern the yield of investment some years hence is usually very slight and often negligible…our basis of knowledge for estimating the yield ten years hence of a railway, copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the city of London amounts to little and sometimes nothing.1

So wrote John Maynard Keynes in “The General Theory of Employment, Interest and Money” published in 1936, one of the greatest 20th century treatises on economics. He doubted our ability to make credible predictions about future investment returns; indeed he opined that such estimation “amounts to little and sometimes nothing”. According to Keynes, people rarely know the probabilities of future economic events. This is because people make decisions in a world that is fundamentally ambiguous and unpredictable where the future can’t be extrapolated from past events. Keynes’ theories have once again been raised to the forefront of economic debate at the time when the world is living through what has become known as the Great Recession of the 21st century, the deepest economic crisis since the Great Depression of the 1930s.

The trouble with economics

It is widely accepted that the capitalist system is susceptible to economic cycles. Some commentators state “capitalism is crisis”; crisis is embedded in the nature of capitalism.2 Why it is, therefore, that with all the sophisticated econometric models and simulations available to economists, we are not able to predict and prevent cycles that seem to be endemic to the system?

What is even more worrying is that there are some who think they have tamed the beast of economic cycles, most recently, and perhaps, infamously, Gordon Brown, the former Prime Minister of the United Kingdom. In the November 2000 Pre-budget Report the then Chancellor of Exchequer, Gordon Brown, stated: “So our approach is to reject the old vicious circle of…the old boom and bust”; and again in the March 2007 Budget Statement he said: “And we will never return to the old boom and bust.”3 Barely six months later, on September 14, 2007, the Bank of England stepped in to provide support for Northern Rock, a mortgage lender that was making fixed rate mortgage loans funded by short-term money market funds. This triggered the first run on a UK bank in more than a century as the financial crisis that first manifested in the USA crashed onto the shores of the UK.

Gordon Brown was not alone in his misguided confidence and optimism. In April 2007, Henk Paulson, as US Treasury Secretary, delivered an upbeat assessment of the US economy, stating that growth was healthy and the housing market was nearing a turnaround. “All the signs I look at” show “the housing market is at or near the bottom,” Paulson said in a speech to a business group in New York. The U.S. economy is “very healthy” and “robust.”4 Eleven months later, in March 2008, the Federal Reserve Bank of New York had to provide an emergency loan to Bear Sterns, the first big name bank that got into trouble, to avert a sudden collapse of the firm. The company could not be saved, however, and was sold to J. P. Morgan Chase for $10 per share, a price far below the 52-week high of $133.20 per share where it traded before the crisis. But this was only the beginning. On September 15, 2008 Lehman Brothers collapsed, threatening the world with financial Armageddon.

Yet again, many of the brightest people on the planet were wrong-footed by events. In the midst of the current financial crisis, Alan Greenspan, the former chairman of the US Federal Reserve Bank, confessed at a Congressional hearing that he was shocked that the markets did not operate according to his lifelong expectations, and that he had made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders.5 Greenspan’s statement and the latest financial crisis shattered the fundamental article of faith based on the concept of homo economicus; an assumption that human behaviour and decision-making is guided by rational, well-defined goals set to maximise total utility of the individual and that businesses and markets, in the aggregate, are self-regulating.

Behavioral economics has become an increasingly prominent perspective in explaining human economic behavior. It may provide some insights to inform traditional economic models and thinking about economic decision-making. Herbert Simon, in his entry in “The New Palgrave Dictionary of Economics and Law” (2009) defines ‘behavioral economics’ as a sort of pleonasm, for what else is economics about than a study of human behaviour?6

I argue that for economics to advance as a discipline and to regain its lost reputation of explaining human behavior, it needs to be open to insights from history and moral philosophy, sprinkled with a touch of psychology.

Behavioral economics

Drawing from history and psychology, behavioral economics offers a radically different perspective to help us understand how people, organizations and markets really operate in comparison to the traditional economic models. Behavioral economics’ lens on human behavior posit that people are bound by biases they are largely unaware of, thus assuming that their behavior is based on rational economic decision-making processes. Much of the hypothesis testing governing behavioral economics is based on experiments carried out in controlled laboratory conditions. Some traditional economists argue that while the results of these experiments are interesting, they do not invalidate the rational models of traditional economics. Relegating behavioral economics to the fringes of economics, they cite the controlled nature of behavioral experiments carried out by psychologists as the reason why these experiments fail to take into account the most important regulator of perceived rational behavior, the large competitive marketplace.7

Another reason why psychological and social aspects of human behavior do not feature in economic theory is that theoretical economics developed rapidly in the 1950s. In its quest to be recognised as a science, economists simplified their models to make them more scientifically rigorous and mathematically treatable. At the time, psychology was an evolving discipline and was yet to branch into the economic domain of human behavior. Whatever the reasons, the near collapse of the world financial markets at the turn of this decade, and the admission by some of the most powerful players in politics, economics and global finance, that they were clueless about the pending economic disaster and what to do about it, has brought the debate about behavioral economics’ contribution to economic thought into the mainstream.

Historical perspective of irrationality

Leading economists, Akerlof and Shiller8, base their work on irrational economic behaviour within the Keynesian framework of ‘animal spirits’ with a special emphasis on macroeconomic implications. Ashraf, Cramer and Lowenstein9 have gone further back in history to Adam Smith’s lesser known work “The Theory of Moral Sentiments”, published in 1759 to demonstrate that the ‘father of economics’ thought that human behavior was not quite as rational as was argued in “The Wealth of Nations”, published in 1776. Smith hypothesised that much of human behavior is driven by ‘passions’ i.e. emotions, but these are moderated by the inner voice of reason, what he called the ‘impartial spectator’. Smith acknowledged that humans are in continuous conflict between their passions and their impartial spectator. The outcome of this struggle may not always result in optimal behavior and economic decisions.

One example of irrational behavior identified by Adam Smith, with consequences to our propensity to save for the rainy day, is present day bias as quoted by Ashraf et al:10

The pleasure which we enjoy ten years hence, interests us so little in comparison with that which we may enjoy to-day, the passion which the first excites, is naturally so weak in comparison with that of violent emotion which the second is apt to give occasion to, that the one could never be any balance to the other, unless it was supported by the sense of propriety…The spectator does not feel the solicitations of our present appetites. To him the pleasure which we are to enjoy a week hence, or a year hence, is just as interesting as that which we are to enjoy this moment.

In other words, Adam Smith thought that the impartial spectator would not differentiate between the utility gained by a person in consuming today versus saving for the future. Indeed, most of us prefer consuming today and worry about the future tomorrow. According to the UK National Office of Statistics, the UK household savings ratio was 4.6% for the first quarter of 2011. At the height of the economic boom in 2006, the savings ratio was 4.9%. Allowing for recessionary factors and low interest rates, the savings ratio has remained stubbornly low. In contrast with Singapore, where the government has aggressively promoted savings through incentives and psychologically appealing stories of national pride; the savings ratio has been around 50% for decades. Even if we did, and many of us do, realize that we are undersaving, Adam Smith’s ‘violent emotion‘ rules the day unless we are incentivised to change our behavior. This insight in human irrationality has been used to develop a new savings product for a Philippines- based bank that helps clients act in line with their long-term interest. Effectively, the saver gives control of their savings to the bank and they are not permitted to withdraw until a certain amount or date has been reached.11

Another well understood bias in behavioral economics, as well as managerial and organisation cognition research, is overconfidence, or a self-serving bias. Adam Smith wrote about the “over-weaning conceit which the greater part of men have of their own abilities”12 Overconfidence often manifests itself in strategy setting by managers overestimating their own firm’s competitive capabilities above those of their competitors. In addition, overconfidence creeps in when managers underestimate difficulties in the integration of mergers and acquisitions, or the complexity and cost of managing projects.

Akerlof and Shiller cite Keynes’ concept of ‘animal sprits’ to argue that decisions may not be as rational as economic theory would indicate:

…there is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic…our decisions to do something positive…can only be taken as a result of animal spirits — of spontaneous urge to action…and not as the outcome of weighed average of quantitative benefits multiplied by quantitative probabilities.13

Animal spirits, a translation from Latin, ‘spiritus animalis’, a spirit of a mind, refers to the basic human energy and life force. In economics it can be understood as consumer and business confidence. Akerlof and Shiller relate animal spirits to optimism which can be used to explain market expansion. This is often associated with the popular perception that the future is brighter or at least less certain than it was in the past.14 Conversely, animal spirits can also explain why we get into recessions, or why economic fluctuations are the norm in capitalism. Keynes again offers guidance in terms of waning animal spirits:

Thus if animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on mathematical expectation, enterprise will fade and die; — though fears of loss may have a basis no more reasonable than hopes of profit had before.15

The lessons from Keynes to modern economics and policy makers is that optimism feeds optimism through a feedback effect, a ‘confidence multiplier’ and ‘money illusion’. As investors become more confident about the state of the economy and the stock market they push up asset prices as more investors enter markets. This will make them richer, or at least on paper, make them feel richer. They will therefore spend more money on houses, durable goods and services, which in turn improves corporate profitability. Profitable enterprises invest in expansion, which in turn results in job creation. As the economy thrives there are fewer loan defaults by consumers and corporations. Banks expand lending at more lenient terms, and as assets that have been placed as collateral appreciate in value, banks’ balance sheets will carry more loan volume and risk. And so it goes on. Unfortunately the confidence multiplier works in reverse. Once pessimism takes hold, the process reverses itself and the overall tightening in the economy can result in asset values undershooting. As investor confidence ebbs, share prices and asset values tumble, resulting in increasingly deteriorating consumer, investor, and manufacturing confidence. This in turn leads a deterioration in the value of collateralised assets, resulting into the tightening of credit. Consumers spend less, companies scale back spending, unemployment rises, loan defaults increase, and the economy enters a recession.

Unlike the rational homo economicus, people suffer from ‘money illusion’. According to Akerlof and Shiller, during an economic boom, people overestimate the real value of their assets, especially the value of their homes. They feel richer as house prices increase, and the value at which their own house was purchased and current market value of it widens. But as people suffer from money illusion, they do not factor into their sense of increased wealth that the replacement cost of their homes has also increased. This overestimated feeling of wealth combined with the confidence multiplier effect can lead people to consume and borrow excessively. Akerlof and Shiller also argue that the money illusion is at least partially responsible for a decline in household savings rates. The increased feeling of wealth drives down our propensity to save.

Bernard M. Baruch, in his 1932 foreword to Charles Mackay’s 1852 published book “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds” wrote:

Anyone taken as an individual, is tolerably sensible and reliable — as a member of a crowd, he once becomes a blockhead.16

Mackay’s book is rarely read nowadays and it is by no means considered a scientific treatise on economics. However, his account of the Dutch Tulipomania of the late 1630s, the Mississippi bubble under King Louis XV of France in 1718, and the British South Sea bubble in 1720 offer the earliest documented evidence of the herding bias. Herding magnifies the above mentioned under- and overconfidence biases. People’s tendency to go with the crowd is well documented in psychological experiments. Fearing that we will lose out of opportunities that others have discovered, we will sign up to investments that others are signing up to even if we didn’t understand them, borrow money because others are doing the same, and ignore risks because others don’t seem to be concerned about them.

Herd behaviour is often accompanied by stories, especially in boom times when optimism runs high. Akerlof and Shiller term these “new era” stories. Returning to Prime Minister Gordon Brown’s statement of having abolished the cycle of boom and bust we can probably explain it through these stories. The story of a new era gained momentum with the press, the public and ultimately the policy makers. Advances in information technology, risk management systems, and the long sustained growth in asset prices heralded a new era when recessions were a thing of the past. To voice a disconsenting view would have earned the pejorative label of a ‘dinosaur’.17

Finally people are loss averse. Loss aversion bias refers to our tendency to prefer to avoid losses rather than to acquire gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.18 We attach more value to the pain of losing £100 than value to the pleasure of gaining £100. This can lead us to sit on investment losses, hoping the market will turn so we do not have to realize our losses; or we become risk seekers. Studies on betting behavior of punters who are down on their luck for the day show that they place bets on risky outsiders on the last day of the race in the hope that they will not fall below their reference rate of zero, e.g. breaking even.

Conclusions and policy implications

History and recent advances in behavioral economics paints a somewhat pessimistic picture of economic behavior. Markets and people do not behave according to the models of traditional economic theory, but are subject to a number of biases. This creates challenges to the economics profession as a whole, as well as to policy makers and individual economic actors. Although a detailed discussion of these challenges is beyond the scope of this paper, some general recommendations can be made.

If markets and economic actors are not rational and self-regulating, then economics has to incorporate the findings of behavioral economists by revising some of the fundamental assumptions of economic behavior. Failure to do so will risk economics and economists being accused of irrelevance and being out of touch of with the real world behaviour of people, firms, and the markets. Science evolves, and the interaction between economic theory and behavioral economics offers an opportunity for economic innovation.

Policy makers are subject to the same economic biases as other economic actors. Therefore it is important that the debate between the behavioral view and economic theory is integrated to governmental policy forums. Behavioral economists have suggested a concept of ‘libertarian paternalism’19. Governments could develop non-intrusive ways of improving people’s decision-making through psychological triggers to protect them from behavioral biases. In 2000, the Swedish government privatized the nation’s social security system. Under the privatization program, every participant who was in the workforce was asked to choose an investment portfolio. Although the government had developed a ‘default fund’, the program was driven by pro-choice strategy that actively encouraged people to choose from 456 funds. The assumption was that people would make rational asset allocation decisions. In reality, people invested heavily in funds with a concentration in Swedish equities, as they felt comfortable with companies that they had an affinity to. In addition, technology funds were highly subscribed as people used past investment returns as an indication of future performance.20

Analysis of investment returns indicates that the ‘default fund’ would have been the best choice for most people. A libertarian paternalistic approach by the Swedish government could have ‘nudged’ citizens towards the ‘default fund’, or a small set of funds, and only provided the comprehensive list of funds for those who had rejected all other options and considered themselves sophisticated investors. The Swedish experience offers a lesson, that more choices people are offered, the more help they require in making decisions.21

Libertarian paternalism could also work in market regulation. Michael Brennan has suggested the introduction of stock market index strips, “S&P 500 Strips”. 22 These strip assets would establish markets for future years’ dividends of particular companies. These assets would provide investors with a focus on the firms’ future performance forcing them to take a longer term view with their investment activity. This could curtail excessive short-term optimism bias by considering the longer-term prospects of the companies.

In terms of improving individual economic decisions and safeguarding against unconscious biases, there is a need to widen the reach of this debate to the general public. In the US, behavioral economics’ view is widely discussed in newspaper columns and popular business press. In the UK, the media, policy makers, and educators have been slow off the mark. The behavioral view should be incorporated in school and university economics curricula, and more research should be undertaken by policy think thanks and research institutes into what positive role can the government play in mitigating against potentially destructive biases without limiting people’s freedom of choice.

The means of researching and understanding of human economic behavior have improved with the advancement of scientific methods of studying human behaviour. Behavioral economics is not a new concept; indeed, Keynes in 1936 wrote that economics is a moral science that deals with motives, expectations, and psychological uncertainties. And even earlier in 1759, Adam Smith, had the foresight to question the limitations of human rationality in making economic decisions. Combining the insights from history and psychology, behavioral economics will advance economics as a discipline and provide opportunities for positive policy making initiatives.

Notes:

1 Keynes, J. M. (1973) Vol. VII The general theory of employment, interest and money, 2nd Ed., Macmillan St. Martin Press, London, p. 149-150.

2 Roubini, N and Mihm, S. (2010) Crisis Economics: A Crash Course in the Future of Finance, Penguin Press, London.

3 http://iaindale.blogspot.com/2008/10/gordon-brown-quotes-of-day.html [accessed: 09.06.2011]

4 http://www.marketwatch.com/story/paulson-says-us-housing-sector-at-or-near-bottom, April 20, 2007 [accessed: 09.06.2011]

5 Ariley, D. (2009) The End of Rational Economics, Harvard Business Review.

6 Shiller, R. J. (2006) Behavioral Economics and Institutional Innovation, Cowles Foundation Paper No. 1150, Cowles Foundation for Research in Economics, Yale University.

7 Ariley, D. (2009) The End of Rational Economics, Harvard Business Review.

8 Akerlof, G. A. and Shiller, R. J. (2009) Animal spirits: How human psychology drives the economy, and why it matters for global capitalism, Princeton University Press, Princeton and Oxford.

9 Ashraf, N, Camerer, C. F. and Loewnstein (2005) Adam Smith, behavioral economist, The Journal of Economic Perspectives, Vol. 19, No 3, Summer 2005, p. 131-145.

10 Ashraf, N, Camerer, C. F. and Loewnstein (2005) Adam Smith, behavioral economist, The Journal of Economic Perspectives, Vol. 19, No 3, Summer 2005, p. 133.

11 http://hbswk.hbs.edu/faculty/nashraf.html [accessed: 01.07.2011]

12 Ashraf, N, Camerer, C. F. and Loewnstein (2005) Adam Smith, behavioral economist, The Journal of Economic Perspectives, Vol. 19, No 3, Summer 2005, p. 134.

13 Keynes, J. M. (1973) Vol. VII The general theory of employment, interest and money, 2nd Ed., Macmillan St. Martin Press, London, p. 161.

14 Akerlof, G. A. and Shiller, R. J. (2009) Animal spirits: How human psychology drives the economy, and why it matters for global capitalism, Princeton University Press, Princeton and Oxford.

15 Keynes, J. M. (1973) Vol. VII The general theory of employment, interest and money, 2nd Ed., Macmillan St. Martin Press, London, p. 162.

16 Mackay, C. (1852) Memoirs of extraordinary popular delusions and the madness of crowds, Vol. I, 2nd ed., Office of National Illustrated Library, Strand, London.

17 McDonald, I. M. (2009) The Global Financial Crises and Behavioral Economics, The Economic Society of Australia, Economic Papers, Vol. 38, No. 3, September, 2009, p. 249-254.

18 Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica 47, 263-291.

19 McDonald, I. M. (2009) The Global Financial Crises and Behavioral Economics, The Economic Society of Australia, Economic Papers, Vol. 38, No. 3, September, 2009, p. 249-254.

20 Year 2000 was at the top of the technology bubble. One of the funds that Swedes had an option to choose from had a return of 534% over the past five years.

21 Thaler, R. H. and Sunstein, C. R. (2009) Nudge: Improving decisions about health, wealth and happiness, Penguin Books, London.

22 Shiller, R. J. (2005) Irrational Exuberance, 2nd ed. Princeton University Press, Princeton and Oxford.