Supplemental Comments on The Great Recession

This is a supplemental comment to the previous blog entry quoting former Federal Reserve Chairman Alan Greenspan testifying before Congress “I did not forecast a significant decline because we never had a significant decline in prices.” He was referring to housing prices.” See Insert

Alan Greenspan is a brilliant professional, and that is the point in noting
that he missed the Black Swan referred to in the discussion of the great recession and vision problems of experts. The point of this supplemental entry is to pose a potential explanation of why that happened in order to aid in enhancing the body of knowledge and improving analytical systems.

The premise for the position spoken by Chairman Greenspan is that that housing prices would not develop behavior different from previous behavior. However, my reading of the Greenspan book, The Age of Turbulence: Adventures in a New World, indicates that may be a too simplistic answer. It could work for congressional testimony, but a better answer is far more complex.

Part of it may be precedent. That part is built upon the fact that econometric models use historic data. However, Greenspan points out that econometricians may make ad hoc adjustments called “add factors.” He notes that “Modern, dynamic economies do not stay still long enough for an accurate reading of their underlying structures.” [See page 36.] He makes the point that “add factors,” ad hoc adjusts are “…often far more important to the forecast than the results of the equations themselves.” He also notes that “But business-cycle and financial models still do not adequately address the innate human responses that result in swings between euphoria and fear and repeat themselves generation after generation with little evidence of a learning curve…we tend to label such behavioral responses as irrational. But forecasters’ concerns should not be whether human response is rational or irrational, only that it is observable and systematic.” He sees this as a missing variable treated with add-factoring. [See page 522.]

The comment, again from the ASPEC seminar essays, is as follows:

Psychological Perspective of Standard Economics - By Jack Lillibridge

In my blog comments on Psychological Perspective of Standard Economics built on my presentation for the Seminar on Strategic Decisions I explored how the theory of complex adaptive systems might suggest ideas to help us understand the current economic crisis, how it happened, possible key causal variables, and likely outcomes. Here is an excerpt with the link to the comments. Psychological Perspective of Standard Economics

A central idea from the theory is that complex systems, such as the economic system, have a dual nature: a stability aspect and a growth aspect. The stability aspect is characterized by balance, continuity, equilibrium, renewal, etc., and the growth aspect is characterized by creativity, learning, exploration, risking, etc. A human being has a similar dual nature: a stability aspect to insure survival and a growth aspect to deal with unexpected challenges and anticipated needs.

The three books: Predictably Irrational by Dan Ariely, Nudge by Richard Thaler and Cass Sunstein, and The Mind of the Market by Michael Shermer, present and illustrate psychological factors that may influence economic decisions in ways not accounted for in the standard economic model. Reading Recommended to Improve Forecast Outcomes

Nudge also describes many examples of a general strategy that may improve such economic decisions. The strategy structures the array of decision options of an economic actor in such a way as to make choosing the most beneficial option more likely without restricting free choice.

A brief recap of some of the psychological factors:
o Anchoring is where first impressions and initial decisions shape many others that follow. Once an initial value or percept is set, we are biased toward that original choice.
o Status quo bias is exhibited as a kind of inertia when making decisions. We opt for what we are used to.
o Loss aversion is where people fear losses more than they desire gains.
o When something is free we forget the downside. We perceive what is being offered as being much more valuable than it really is.
o An automatic pilot mode is where people are not actively paying attention to the task at hand.
o A variation of this is where people rely on beliefs, heuristics, models, theories,
etc. without paying attention to whether they are still appropriate in the current situation.

There are many other psychological factors that might be relevant, such as expectations, short-sightedness, self-justification, curiosity, etc., not explicitly dealt with in the books reviewed.

A nudging strategy is based on affecting the array of choices available to the decision maker in the context in which the decision is made. A nudge then is any aspect of the set of choices that alters people's behavior to make a beneficial choice more likely while maintaining real freedom to choose.

A possible limitation to the implementation of nudging strategies is that we don't know our preferences completely - we discover them through market processes and through the process of making decisions. We also don't fully know what future choice sets will look like, let alone what our preferences will be at that time. Designing strategies to affect unknowable incentives and outcomes will be difficult and perhaps not possible in some cases.

A few nudge examples to illustrate how they work:
o Anchors can serve as nudges. We can influence what you will choose in a particular situation by subtly suggesting a starting point for your thought processes.
o A default option serves as a powerful nudge. Providing a well-diversified and balanced investment portfolio is a default.
o Synchronizing pay raises and savings increases means participants never see their take-home amounts go down, and they don't view their increased savings as losses.
o Just before a dangerous curve, white stripes are painted every so often perpendicular to the direction of traffic. At first they are equally spaced. As the curve comes close, the lines begin to be progressively closer together. This gives drivers the sense that their driving speed is increasing and they slow down.

The effectiveness of each example is based on one or more of the above noted psychological factors. For instance, the use of painted stripes to get drivers to slow down is based on a kind of automatic pilot mode, where drivers pick up indications of things happening in their environment outside of their conscious awareness.

An important issue for those trying to understand the current economic crisis is how psychological factors could impact decisions collectively arrived at by economic actors, both individuals and institutions. It important to understand how such factors could be appropriately incorporated in a modified economic model.

One way to address this issue is to see psychological factors as reducing the quality and completeness of the actor's information. The standard economic model has erroneous assumptions relevant to the decision. {Please read the entire essay, Psychological Perspective of Standard Economics)

Posted by Maury Selding on behalf of Jack Lillibridge. The comment was prepared prior to the blog opening and the link is to an essay prepared by Dr. Lillibridge for Maury's seminar at ASPEC. Dr. Lillibridge has a Ph.D. in Psychology.