Archive for June 16th, 2010

I think James Kwak makes some great points on applying behavioural economics to the current crisis. We must not let that approach excuse the worst of corporate excesses:

First, it doesn’t do to say that ordinary people are irrational in making ordinary everyday decisions, and therefore we have to accept that companies will be irrational in making big decisions — like, say, whether to drill holes in the Earth’s crust a mile under the ocean. As they say, people make big bucks to make these decisions, and we expect them to use a little more reasoning than the kind we evolved on the African grasslands…

The problem is that there is a systematic bias within these companies against certain assessments and in favor of others. That is, the guy who shouts, “Danger! Danger!” will be ignored (or fired), and the guy who says, “Everything’s fine, the model says disaster can strike only happen once every hundred million years” will get the promotion — because the people in charge make more money listening to the latter guy. This is why banks don’t accidentally hold too much capital…

On top of that, it isn’t even true, as a matter of fact, that the companies involved failed to estimate the risk of disaster…

This isn’t inability to quantify the likelihood of unlikely events; this is willfully looking the other way.

Thaler also wants to make the point that regulators are incapable of understanding the complex technologies involved, whether in finance or in oil exploration. But while this is undoubtedly true to an extent, it also misses the main point.

The most frightening part of Lustgarten’s interview has nothing to do with BP. It’s about the use of hydraulic fracturing (or “fracking,” apparently with no intended reference to Battlestar Galactica) to drill for natural gas. In fracking, a mixture of water and chemicals is injected underground under extremely high pressure to break up rock formations and release trapped natural gas bubbles. According to Lustgarten, there is no scientific understanding of what happens to those chemicals — many of which are toxic — and whether they end up in our drinking water. Yet the Energy Policy Act of 2005 forbids the EPA from regulating fracking under the Safe Drinking Water Act — by simply stipulating, without proof, that the chemicals are removed after being used, and therefore there is nothing to regulate.

If this reminds you of the Commodity Futures Modernization Act, it probably should…

This is what happens when you have a weak regulatory agency crippled by pressure from above (and political appointees who are opposed to regulation) and a private sector that simply does whatever it pleases in pursuit of profits. It’s not individual irrationality; it’s power, pure and simple. Free market economics has already whitewashed enough egregious corporate behavior. Let’s not repeat that mistake with behavioral economics.

Combining behaviorial economics with power analysis would be an excellent step towards making it a form of real-world economics. Power analysis would help provide some of the “why?”, not as in “why do people make certain decisions,” but “why are certain people in position to make those decisions?” The preferences that are behind decision-making are not merely exogenous either. I think behavioral economists understand these concepts at an intuitive level, but I don’t think they sufficiently incorporate them into their formal models.


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