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Last Updated: Jan 12, 2009 - 9:52:22 AM |
For roughly two decades, the new science of behavioral economics has
been challenging what economists call “rational choice theory.”
Rational choice theory described that primate species called Homo
economicus—Economic Man—as rational, profit-maximizing, and efficient
in making choices. When faced with a decision, the theory held, we
carefully consider the value of an outcome and make a rational decision
about the most efficient course to take to maximize the utility, or
profit, of that outcome.
But research in behavioral economics has revealed that many, if not
most, of our economic choices are driven not by rational calculations
but by deep and unconscious emotions that evolved over the eons. Among
these irrational emotions is “risk aversion,” a psychological effect
that is actually part of the reason that financial markets work so
well. People are more averse to risk than traditional economics would
dictate, and that restraint helps keep most speculative market behavior
in check.
As everyone knows by now, many of our major financial institutions
weren’t nearly averse enough to risk over the last decade and a half.
In seeking quick and carefree profits, along with trying to appease
politicians pushing for wider homeownership, they tossed all restraint
out the window, with devastating economic consequences. How did this
happen, and how can we keep it from happening again?
Imagine that I give you $100 and a choice between (A) a guaranteed gain
of $50 and (B) a coin flip, in which heads gets you another $100 and
tails gets you nothing. Do you want A or B? Now imagine that I give you
$200 and a choice between (A) a guaranteed loss of $50 and (B) a coin
flip, in which heads loses you $100 and tails loses you nothing. Do you
want A or B? The final outcome for A in each scenario is the same
(winding up with $150); so is the final outcome for B (an even chance
of winding up with $100 or $200). So rationally, whether you are in the
first scenario or the second, you should make the same decision, which
is what rational choice theory predicts.
But behavioral economists have discovered that most people choose A in
the first scenario (a sure gain of $50) and B in the second (avoiding a
sure loss of $50). Even though there is no rational difference between
having $100 and a sure gain of $50, and having $200 and a sure loss of
$50, there is an emotional difference. That emotion is risk aversion,
and thousands of experiments have demonstrated precisely how averse to
risk we are: on average, most people will reject the prospect of a
50/50 probability of gaining or losing money unless the amount to be
gained is at least double the amount to be lost. Losses, it turns out,
hurt twice as much as gains feel good, and it is our emotions—not our
reason—driving our risk-taking decisions. All other things being equal,
only when the potential payoff is more than double the potential loss
will most of us take the investment gamble.
So deep and powerful an economic emotion is this aversion that it may
be an evolved trait. Food is probably at the root of it. Before human
beings domesticated plants and animals, our nomadic ancestors had to
hunt and forage to survive, and food was so scarce that hoarding was
necessary for survival. Those individuals who valued food the most were
more likely to survive and thus pass on their genes for hoarding
behavior—and its corresponding emotion of valuing highly what is
hoarded, whether food or something else.
Though risk aversion and its attendant fear of loss seem irrational by
traditional economic standards—we tend to think of emotion as
antithetical to reason—when allowed to operate, they’re an important
reason that financial markets usually work so well. Interfering with
them can wreak havoc.
Though the financial crisis is complex and has many explanations, one
of its primary causes involves Fannie Mae and Freddie Mac, the nation’s
largest guarantors of home mortgages. Recall that Fannie and Freddie
are government-run organizations that do not make loans directly to
customers; rather, they buy loans from the banks that make those loans
directly. In spring 1999, Fannie and Freddie—under pressure from the
Clinton administration—increased their portfolio of loans to lower- and
moderate-income borrowers from 44 percent to 50 percent by 2001. That
meant granting loans to higher-risk customers.
Now, there’s nothing wrong with corporations’ and institutions’ taking
higher risks, so long as they adjust for it by charging more. The
higher price acts as a risk signal to both buyers and sellers, thereby
dialing up their emotion of risk aversion. That’s what Fannie Mae was
already doing, in fact: when it purchased loans that banks made to
high-risk customers, it bought only those that charged 3 to 4
percentage points higher than conventional loans. But under the new
program, Fannie would buy high-risk mortgages that were only 1 point
above a conventional 30-year fixed-rate mortgage (and that added point
would be dropped after two years of steady payments). In other words,
the normal risk signal sent to high-risk customers—you can have the
loan, but it’s going to cost you a lot more—was removed.
And risk aversion can’t operate, of course, without a risk signal.
Lower the risk signal and you lower risk aversion. The result helped
give us today’s financial crisis. Similarly, the $700 billion
economic-recovery package will only make matters worse because it, too,
will short-circuit our normal aversion to risk. The package signals to
the marketplace that if the system fails, the government will bail it
out. Clearly, there’s no need to be risk-averse when Uncle Sam will
cover your losses.
An appropriate analogy is the world of sports, in which athletes do
their best to win games within the rules established by each sport’s
governing organization. Ordinarily, the rules against cheating
reinforce the instinctive risk aversion of athletes, who don’t want to
take the chance of being caught. But when sports’ governing bodies
either relax the rules or fail to enforce them—think of steroids in
baseball or doping in cycling—it signals to athletes that there is
little risk in pushing the boundaries of the sport. Diluting their risk
aversion encourages some to game the system, and once the top
competitors do it to get a slight edge over their immediate
competition, everyone else has to do it just to compete. The result is
a catastrophic collapse in the sport’s integrity.
Similarly, when the government intervenes in the natural dynamics of
the marketplace by, say, encouraging corporations to relax the rules of
financial transactions, and then signals to them that if the system
fails it will bail them out, it tells market players that they face
little risk in pushing the boundaries of the market. Lowering financial
risk aversion encourages boundary-pushing, and once the top
corporations do it, everyone else has to do it just to compete.
The purpose of capitalism, we unfortunately need to recall, is to make
a profit. Low risk-taking typically results in slow and steady profits,
whereas high risk-taking can produce both high profits and steep
losses. By entering the business of risk protection, the government has
reconfigured the economic game: in profits, we’re capitalists; in
losses, we’re socialists.
Let’s be brutally honest. The CEOs, CFOs, and COOs of the Wall Street
financial giants who signed up for our new corporate welfare program
are now welfare queens. They’re on the dole. In an ideal world, they
would all be put on a very public welfare-to-work program—as in the
welfare-reform movement of the 1990s—that tethered salaries directly to
the amount of money paid back, with interest, to the people who earned
the money in the first place: taxpayers. The corporate leaders could
even appear on a new Fortune 500 list, ranked by how much of our money
they had returned.
What would help ameliorate future financial crises? The government
should not be in the business of hiding real risks through political
imperatives, or of insulating corporations from the risks that they
have freely taken. Doing so confounds the normal risk signals that keep
the market in balance. For risk aversion to keep markets working,
people and corporations have to be allowed to assess real risks and to
fail if they take inappropriate risks. Only the people who produce
wealth can properly assess how best to risk it in future investments.
The Warren Buffetts of the world can do that. The Ben Bernankes cannot.
Source:Ocnus.net 2008
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