A book about two psychologists who have altered the way we think about the way we think.

For many people, Michael Lewis is best known for his 2010 book The Big Short and the follow-up film, which describes the carryings-on of the financial sector in the American housing market which underlay the Global Financial Crisis. In fact he has written over a dozen books beginning with Liar’s Poker in 1989 which, by describing the culture in the New York finance industry, presaged the crash a decade later. 

Many Americans know him best for Moneyball (2003), in which he describes how one of the poorest professional baseball teams was able to achieve high performance compared to richer teams. Oakland Athletics, which spent $US40m on salaries in 2002, outplayed the New York Yankees with their $US120m spend. Essentially Oakland selected their team by systematically purchasing undervalued players rather than by relying on the judgements of its talent scouts and managers. 

There is an economic story here. It is normal to assume that businesses – like the All Blacks, big league baseball is a business – operate (near) efficiently, getting the maximum return on outlays. But Moneyball showed that the baseball industry did not. Perhaps this is a widespread problem throughout business; in which case quelle horreur! A fundamental assumption of how the capitalist economy is ruptured. 

But Lewis did not appreciate then that lurking behind this failure was an even more fundamental question: why people were making poor quality decisions. Traditionally economics assumes that people act rationally. Do they?  

In his latest book The Undoing Project Lewis explores this by tracing the lives of a couple of Israeli psychologists, Amos Tversky and Daniel Kahneman (who wrote Thinking, Fast and Slow), Kahneman was awarded a 2002 Nobel Memorial Prize in Economic Sciences. Tversky had died from cancer six years before and was not eligible – like Rosalind Franklin of the double helix. Had he survived he would certainly have joined his co-worker – as she would have.  

In fact there are similarities between the Watson and Crick team and Kahneman and Tversky. Two very different personalities with differing backgrounds worked together brilliantly. I am not sure which team made the more profound discoveries.  

(Lewis portrays the psychologists’ relationship as if it was a marriage – with no sexual overtones. It went through difficulties as marriages do, ending in a ‘divorce’. Three days later, Tversky rang Kahneman to say he had been told he had terminal cancer. Kahneman gave the eulogy at the funeral six months later – all very romantic.)  

The book describes the research which led them to the conclusion that people do not always choose optimally and that the heuristics they instead use are not always near-optimal. They can even give contradictory answers. For instance, told that a particular surgical operation has a 90 percent of success one is likely to take it up; told that it has a 10 percent rate of failure the same person is likely to turn the opportunity down. The two statements are logically equivalent but the way the logic is presented affects the decision. 

Because it is scientific research the experiments may seem artificial, but that is because they are designed to avoid ambiguity. Astonishingly, even experts can give poor answers. In an early study some surveyed statisticians gave wrong answers to elementary probability problems; how you, dear reader, can expect to get them right is uncertain. But by the end of the book you should be convinced that any rationality assumption for homo sapiens has to be used with the greatest caution.  

This does not mean that it can never be used. For simple choices – such as oranges or apples – the assumption may be useful. For complex ones which involve future uncertainty – such as consuming and saving over time – the assumption of pure rationality is almost certainly misleading. 

Lewis claims that the findings of Kahneman and Tversky and the other developers of behavioural economics are now well incorporated into economics. I am not sure this is true – at least not in New Zealand. For instance, there is no ‘nudge’ unit here which tries to apply the lessons to the practical interactions between government and the public. There are New Zealand university economists working in the area, but I do not get the impression that the majority of economics graduates are well trained in behavioural economics. 

Some economists reject the approach. The older ones may not be up to speed. Keynes wrote that ‘in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest.’ 

Other economists have too much of their research invested in the rationality assumption to change their mind when the evidence says they should. 

Some are ideologically fearful that abandoning the assumption of rationality justifies paternalistic interventions by the state. It need not, since those operating on behalf of the state are as prone to irrationality as those they are operating on. 

We all suffer from the irrationality. Both Kahneman and Tversky admit that they make errors like everyone else. Tversky remarked that ‘[m]y colleagues study artificial intelligence; me, I study natural stupidity.’ 

Nor should we confine the impact of the findings only to economics. Kahneman has said that ‘[n]o one ever made a decision because of a number. They need a story.’ He is reporting on tightly designed experiments, but I think we are allowed to adapt his maxim to ‘no one ever made a decision because of a fact. They need a story.’ 

As the research shows the story need not be particularly attached to the fact(s) nor need it be coherent or consistent. Sounds like a lot of the support for Trump does it not?(To be balanced, those in other parts of the political spectrum can be equally irrational – the way some once supported the Soviet Union for example.) 

If you read Thinking, Fast and Slow you would want to read The Undoing Project to enrich your understanding of the themes of the first book (plus there are some jolly good biographical stories – including their involvement in the Israeli military). And if you have yet to read Kahneman’s book you should, if you want to understand one of the major sources of unrest in public policy thinking – and why you and others (and I) sometimes make very stupid mistakes. Then on to Michael Lewis’s book.

Comments (9)

by Andin on December 22, 2016
Andin

" the rationality assumption "

I thought the logic was people acted in their self interest and that was able to be explained in a rational way. Or reasoned and understood in a way that was rational or something.

If I can just say apart from the fallacy of such logical assumption. It was, and I will apportion some blame here,  certain sections of western society who thought they were too clever by half and threw out centuries of thought about the human condition thinking they knew better. There is no point trying to name them, not that I could, they tried  to remain nameless hiding behind this rationale.

We've just got to find our way back to some sort of sense. Thats going to be difficult enough

by Dennis Frank on December 22, 2016
Dennis Frank

Excellent, Brian.  I've been a Michael Lewis fan since Liars Poker (found discounted to $5 in the early '90s.  Having read & owned thousands of books, there's few writers that I'd call brilliant:  he's one.  Though psychology is distinguished more by collective inadequacy than accomplishments (exceptions to the rule being Jung, Jaynes, Goleman) I'm intrigued enough by your recommendation to act on it.

The rationality paradigm economists still cling to was ditched by physicists almost a century ago.  I suppose the feeble excuse economists would offer for being unable to keep up with the play is the silo-thinking imposed on them by academic culture. 

But it's not as if multi-disciplinary endeavour is still radical leading-edge, is it?  Plenty of synthesis has been happening all over the place the past quarter of a century - more than thirty years since folks like Capra, Wilber & Sheldrake popularised Kuhn's notion of the paradigm shift in science.  Perhaps economists just have been waiting for one of their number to perform the feat in economics?

Incidentally, the Jevons paradox alerted us to the perverse effect of psychology on folks who are trying to green the economy, but is it true?  Here's an interesting critique of the Jevons paradox:  https://thinkprogress.org/debunking-the-jevons-paradox-nobody-goes-there-anymore-its-too-crowded-7fec531b1411#.rivuay4r5

by Brian Easton on December 23, 2016
Brian Easton

The statement that people act in their self interest, Andin, is a tautology. What is their self interest?

Economic analysis often assumes that people only think about themselves and not their family, associates, the wider community, the nation, the environment and so on. At more advanced stages the assumption can be relaxed, although sometimes the analytics gets frustratingly complicated. (A famous paper by James Tobin considered what happened if one had other people’s utility in each individual’s utility function – a simple example is that you care about the wellbeing of your family and will make sacrifices to enhance it; like giving them Christmas gifts. Under this assumption, the standard welfare economics theorems do not apply and the market signaling system becomes inefficient.)

In public policy the self interest assumption has another role. It is a humble acceptance that usually no one else knows better than the individual what her or his best interests are. (There are exceptions of course; public policy tends to carefully define them.)

The reason, Dennis, why many economists ‘cling’ to the rationality assumption is that there is no rigorous comprehensive alternative. At the moment the results used in behavioral economics are a set of results which do not readily come together as a coherent whole. I am about to write a column listing them; you will see what I mean.

My view is that economics should be aware of the limitations of the self interest assumption; providing we are, we can use it. One example is the analysis shows that the pursuit of pure self interest can be socially disastrous – as The Big Short illustrated.

by Dennis Frank on December 28, 2016
Dennis Frank

So what rationalisation do economists use to ignore the common interest? Examples of people working together for mutual-benefit outcomes abound in the history of humanity.  One could even note that they power capitalism (albeit that it minimises the benefits to non-owners by design).  What causes the ideological aversion to anything other than self-interest?

In hunter-gatherer society some hunt (men), some gather (women) and it was a sustainable village & tribal economy for millennia.  This is replicated in indigenous group ecologies all over the world still, the amalgamation with the invading global capitalism notwithstanding.  Economists can't learn from such natural synergies?

Perhaps economics can only integrate social systems based on money, can only describe artificial economies.  If so, doesn't that make it a delusional belief system?

by Brian Easton on December 29, 2016
Brian Easton

I do not think it is fair, Dennis, to say that ALL economists ignore the common interest; there is a very big economic literature on it. Rather they start of with the assumption of self-interest in explaining behaviour, but good ones do not try to jam all human behaviour in this Procrustean bed. Some do (especially neo-liberals), I'm afraid; other economists criticise them.

Incidentally, an example of your Jevons Paradox is that a road with increased capacity (say an extra lane) may prove just as crowded in rush hours. Economists can explain not only why this happens but how people may be still better off. 

 

 

by Dennis Frank on December 29, 2016
Dennis Frank

Thanks for the feedback Brian.  My negative view of economists derives partly from not having studied it & partly from negative views commonly-expressed in the media.  I'm happy to be educated about any positive dimension the belief system may have.

In particular, I'd like to see how the common interest is integrated into the belief system - whether it's just taken for granted, or structurally developed into theory that is relevant to the future of humanity.  The green movement simply incorporated the notion of an economy sustainable in perpetuity as a principle.  This notion of stasis derives from observation of natural fluctuations (around a rough average) - but now we know ecosystems sometimes evolve out of a dynamic equilibrium.  Unfortunately complex systems aren't accurately modelled, even by the science of complexity.

I suspect future economics must formalise somehow the common interest of a group in a generic sense, to provide a theory incorporating incentive-structures.  It may not be easy or even possible to translate this into algorithms - but it would enable leftists to finally move beyond socialism, by showing how working together can be more than just a slogan driven by wishful thinking.  Mutual benefits could be seen as part of a plan, with a generic theory applicable to any social context...

by Brian Easton on January 02, 2017
Brian Easton

I think, Dennis, you need to distinguish between economics as a science and economics' role in policy. The common interest is usually about the latter: when we are thinking about (or advising) what should be happening we have to use criteria about why one situation is superior to another. 

Economics have thought a lot about this going back to the development of welfare economics about a century ago. It is a tortuous road, but some highlights.

About 80 years ago there was a tendency to use a 'social welfare function' to evaluate the situations which implied some common interest. But usually they involved making comparisons between people and economists said they did not have the expertise to make such judgements. So they shifted over to the notion of a 'Pareto improvement' where some people are better off and nobody is worse off. That rarely happens so they moved onto making judgements based on compensation: that is those who are better off could compensate those who were worse off. Under certain conditions that is equivalent to an increase in GDP. However policy makers frequently ignore that requires that people who are made worse off need to be compensated for an improvement in community welfare; instead  they take an increase in GDP as a good thing even though some are made worse off. 

A further complication is that about 60 years ago it was found that plausible welfare choices could be irrational when a community chose A over B, B over C, and C over A. This is known as the 'Arrow Paradox'. It turns out that the research on which behavioural economics is based has found that this 'intransitivity'  can also be occur in individual behaviour. (Bother!)

One sort of solution to the community interest challenge is to give property rights to individual; an interesting example is the RMA which by including sustainability gives property rights to future generations.  (One is not surprised that current generations often chip away at these property rights.) However economists have not been able to find a useful criteria as to who should get the property rights. 

This does not strictly answer your query, Dennis, What I have tried to get over is that economists have long thought about the issues and that it is complicated. Sadly though, it is often badly taught.  I doubt that any New Zealand policy studies program gives the amount of time to these issues that I would. 

 

 

by Dennis Frank on January 02, 2017
Dennis Frank

Hmm.  I presume the issue transcends economics then.  I recall my irritation with market forces provoking me into pointing out to an adherent to the ideology that families don't operate accordingly.  If they did, the alpha male would grab most of the food, the next-best grabber would get most of the remainder and so on...

He didn't respond to the email.  I could have pointed out that family meals normally provide equity shares to all.  Could've said "Kinda socialist, eh?"  But with slow learners who are actually intelligent, it's usually better to not labour the point.  So economists can't provide a design for social equity as part of their collective discipline.  Perhaps their failure to learn from the ongoing success of Mondragon & other successful alternatives to traditional capitalism is due to tacit acceptance that social darwinism is essential to public policy?

by Richard Keller on March 18, 2017
Richard Keller

Where we need to step up here is to recognize that it is not only psychology (of the individual) at play, but also the sociology of existing within a culture.  Today that is probably more noticeable than usual as we are experiencing fundamental change and fast change to our way of life to an unprecedented degree.  Those kind of things are experienced more at the culture level than the individual.  People, rich and poor, are terrified of the changes mooted by climate change; changes that will effect everyone.  This does not reflect "a change in the way we think."

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