Nice intro form Option Armageddon for very interesting interview with Nobel Laureate Daniel Kahneman, an expert in behavioral finance. Flawed economic models rulez our world today..
Option Armageddon: Much of economic theory is flawed because its models assume people act rationally when of course they don’t. And yet economists and central bankers continue to make predictions based on these flawed models because, well, they don’t have better ones. Or the better ones that do exist yield inconvenient results that are more easily ignored than dealt with. Despite this, many of the rest of us continue to rely on discredited economists because, again, we’ve got few other choices.
…the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.
They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, “We suddenly found a map.” The officer looked at the map and said, “You found a map, all right, but it’s not of the Alps, it’s of the Pyrenees.”
photo by Pickelweasel
According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless.
From Kahneman’s point of view, the most important moment of the recent economic crisis came when Alan Greenspan admitted at a congressional hearing that his theory of the world had been mistaken. “Greenspan expected financial firms to protect their interests, because they are rational companies and the market is rational, so they would not take risks that would threaten their very existence,” Kahneman says.
“Where did he go wrong? Because he did not distinguish between the firms and their ‘agents’ [their managers]. There is a huge gulf between the companies and their agents. Firms take the long view, while agents have short perspectives and take the short view. The compensation models of the corporation and their agents are different. The executives did not commit suicide when they took risks; it was the corporations managed by these agents that committed suicide.
“People are always asking me: ‘Are the people who got caught up in the financial crisis idiots?’ The answer is, the bank managers were not complete idiots. Greenspan’s admission speaks for itself: The theory that a bank is some sort of rational agent that protects the public’s interest is wrong. The assumption of rationality is a fallacious one in the first place, and in the second place, the assumption that a bank should be seen as a single, rational player is irrelevant. One must look at who is managing the bank - management that receives incentives to do things that are not connected to anybody’s interests.”
read the full article here
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