Friday, 20 November 2009

Irrational Decision Making

Emotional and social factors are rarely taken into account when developing ideas on economics. I just read a great article by Professor James B. Duke on why they should be taken into account.

Which camp do you fall into after the economic crisis? Will the crisis change your buying habits or will you change? Here's the conundrum - some will say that because of the crisis they will no longer have a big mortgage or have such huge credit card debt. Then there will be some who think that they have saved for years and now see their savings depressed in the crash and they might think that they have missed out as their purchasing power has declined over time - perhaps they might spend more rather than save for the future because in reality, they haven't saved anything.

In some respects, this is the dilemma our economy faces. We are creatures of habit and so as the economy recovers we will probably revert to type and spend more - but until we see it recover we will more likely hang onto our cash believing that we may be at risk due the economy. It's the sort of circular argument that economists have tried to break by advocating Government spending and Quantitative Easing (QE) to give the economy a 'virtual' boost as it is money we don't have. Economists believe that the market will pick up but they lack the ability to factor in the human emotional and social dynamics which will actually play an important role in any recovery.

Here's an experiment which sort indicates this. Two players are given £10 each. Then player 1 is given a choice - give player 2 their £10 and player 2 will give player 1 half of their money back - or player 1 can keep the £10 and go home. Player 2 has the choice of keeping the £10 they have and the £10 they are given so they can leave with £20 or indeed give half the money back to player 1.

Then a nuance is added, as player 1 gives £10 to player 2, the £10 is quadrupled so that player 2 actually receives £40 and then has £50 in total. Player 2 has the choice of giving half back (i.e. they both finish with £25) or walking away with £50.

Now the rational perspective is that player 2 will never give any of the money back so the prediction is that player 1 keeps the £10 and goes home because they do not expect any of the money back. However, human nature appears to be more trusting as in the experiment it was found that there was a good chance that player 1 gave the money to player 2 and that player 2 would reciprocate and give half their money back. But the more interesting aspect was that if player 2 walked away with the £50, then player 1 is invited, having lost their £10, to give £1 to the experimenter and for every £1 given, the experimenter takes £2 off player 2 - so give them £2 and they take £6 off player 2 and so on. Rationally, why would player 1, who had just lost money, pay more money just to see player 2 punished? The reality is that people often do exactly that - spending money to effectively express revenge even when revenge is irrational.

This is a trust game and it mimics exactly what we have been through as investors in the last two years. We have ploughed money into investments and pensions in the past and we expect fair play from the providers. Now that these investment companies and banks have blown all the money and expected us all to bail them out, our trust has been broken as they have effectively walked away with the 'experimental £50'. Consequently we feel betrayed.

Professor Duke asserts that this trust needs to be rebuilt and it means that we have to get some understanding of what is going on in order to invest again. He believes there should be new regulations, more transparency and removals of conflicts of interest in order to rebuild our trust. But perhaps the most basic of human nature is at work too, and I know I really empathise with this, we also want to see the perpetrators to feel pain too.

I have to say that I am in that camp that says I really resent that I have been asked to bail banks out without seeing hardly any of the executives and traders who caused the crash suffer - in fact, we are griping and arguing on how to limit their pay rather than stopping them trading. The reality is that even if we attempt regulate their bonuses with laws that in practice cannot be applied they have not suffered for what they have done.

Perhaps this is one of the reasons why the recovery is a great deal slower than anticipated and it is why our Government consistently miscall that borrowing they need. One thing is for sure, the trust of every day people has yet to be repaired over the banking collapse and I, for one, am still not comfortable about paying for other people's mistakes and greed - now or ever.
James B. Duke is a Professor of Behavioural Economics at Duke University, North Carolina and is the author of 'Predictably Irrational'

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