A psychologist's perspective on the markets
The science of economics is founded on a bedrock principle: People do what is in their best interest. But this sweeping pronouncement doesn't seem to explain what we see in front of us. People can't understand what will benefit them. They have incomplete information or impulsively follow the crowd. And losses, as we've seen, make a bigger impression than gains.
A milestone in understanding actual economic behavior came in 2002, when psychologist Daniel Kahneman of Princeton University won the Sveriges Riksbank Prize in Economic Sciences (the economic Nobel) for his work in jump-starting the study of actual (not theoretical) economic behavior.
For a behavioral perspective on the modern market meltdown, we phoned Dan Ariely, a professor of behavioral economics at Duke University, who wrote "Predictably Irrational, The Hidden Forces That Shape Our Decisions."
When we asked about the role of fear in the markets, Ariely responded by turning the topic to mistrust, then illustrated his point with a game behavioral economists play in the lab. When the game starts, players A and B each get $10. If A gives $10 to B, that sum will somehow quadruple, leaving B with $50, total. B can then split the money with A, or exit stage left with the whole wad.
None of this would happen, according to standard economic theory, because A would want to maximize his own benefits and would have no reason to trust B to split the $50. No money would change hands, so each player would sacrifice the chance for a $15 profit. But in reality, A may fork over the $10, trusting B to split the money, and B is likely to do so.
B, of course, would be free to walk off with the whole pot, which would doubtless annoy A, and now comes the kicker: What if A has an opportunity for revenge? Imagine we tell A that he can go home, send a check to a particular organization, and for every dollar he sends, player B will lose $2. In essence player A can lose more money to make player B suffer. In this situation, most people do go for revenge, Ariely says. "When we look in the brain, the part that gets activated when people plot revenge is the striatum - the same area that gets activated by heroin, which suggests that revenge is pleasurable."
Is irrationality rational?
Comnig back to Wall St., the game seems to explain some of the vehemence felt toward corporate leaders who have contributed to the meltdown, Ariely says. "We trusted them, gave them our retirement funds, and basically they have betrayed us." He thinks the first federal bailout proposal was blocked due to this desire for revenge: "I am willing to lose money if it means these SOBs lose more."
Revenge also motivated the prohibitions in the bailout against golden parachutes for the execs who scurried away from the smoldering ruins of failed banks, Ariely adds. "From a rational perspective, who cares about few hundred million dollars [when the bailout was supposed to cost $700 billion]? But we care a lot, because of the revenge aspect. If they are using our tax money to bail out a bank, there should be some measure of revenge: maybe all their stock options should go back into the pool, or maybe we can force each bank that takes public funds to create a new set of rules about immoral behavior."
Making life safe for cheaters
The bizarre financial structures on Wall St. have taken their share of blame - if they are incomprehensible to experts, what are untutored investors supposed to do? -- but Ariely claims that they are also conducive to cheating, then illustrates with another experiment: "I have a sheet with 20 simple math problems. Everyone can solve them given enough time, but I do not give them enough time. I offer $1 per question for correct answers. Some people solve these, hand in the paper and get paid. This is the control condition. Other people are asked to shred their worksheet when the time is up and tell the experimenter how many they have solved. Perhaps not surprisingly, many people cheat a bit."
But when the immediate reward is changed to a token that can be immediately exchanged for a dollar, "Cheating increases drmatically," Ariely says. "This is a very sobering experiment. These people were cheating for tokens that were only one step removed from cash. Think about the executive who is backdating stock options, it's multiple steps and a much longer time span. With these complex financial tools, it's much easier for people to cheat."
Most people are more or less ethical, he says, but even good people can see the world in a way that fits them financially. "The bankers see the world in a way that suits them," he says. "To cheat on Wall St., they just have to shave a fraction of a penny, pay themselves too much, do things that are almost honest."
Simply too complex?
With so many math geniuses working on Wall St., the number and variety of fiendishly complex financial "instruments" should not be a surprise, but Ariely contends they have surpassed our understanding. "We have created a mechanism that is way too complex for us, it doesn't suit our human abilities, and I think we have to simplify, create something that is in the range of human understanding."
Modern highways, he says by way of analogy, are built to compensate for uneven driving abilities. "I am a bad driver, I make multiple mistakes," he says. "So far, I've not had an accident. The reason is the roads: The margins are really wide, and they have these markers that tell me when I move across the lanes. The roads are built for irrational people, for people who can't drive" very adroitly.
If the roads were designed by financial engineers, he says, the margin for error would disappear. "They would make the lanes one inch wider than a car, and the car would go 200 miles an hour. That would be 'efficient,' but it would not be built for irrational people who make mistakes."
In other words, mental matters matter. In economics, Ariely says, "Aside from the equations, everything else is full of psychology."