The behavioral revolution
By David Brooks
International Herald Tribune
October 28, 2008

Roughly speaking, there are four steps to every decision. First, you perceive a
situation. Then you think of possible courses of action. Then you calculate which
course is in your best interest. Then you take the action.

Over the past few centuries, public policy analysts have assumed that step three
is the most important. Economic models and entire social science disciplines are
premised on the assumption that people are mostly engaged in rationally
calculating and maximizing their self-interest.

But during this financial crisis, that way of thinking has failed spectacularly.

As Alan Greenspan noted in his congressional testimony last week, he
was "shocked" that markets did not work as anticipated. "I made a
mistake in presuming that the self-interests of organizations, specifically
banks and others, were such as that they were best capable of protecting
their own shareholders and their equity in the firms."

[Blogger's note: Greed tends to be short term, apparently.]

So perhaps this will be the moment when we alter our view of decision-making.
Perhaps this will be the moment when we shift our focus from step three, rational
calculation, to step one, perception.

Perceiving a situation seems, at first glimpse, like a remarkably simple operation.
You just look and see what's around. But the operation that seems most simple is
actually the most complex, it's just that most of the action takes place below the
level of awareness. Looking at and perceiving the world is an active process of
meaning-making that shapes and biases the rest of the decision-making chain.

My sense is that this financial crisis is going to amount to a coming-out party for
behavioral economists and others who are bringing sophisticated psychology to
the realm of public policy. At least these folks have plausible explanations for why
so many people could have been so gigantically wrong about the risks they were
taking.

Nassim Nicholas Taleb has been deeply influenced by this stream of
research. Taleb not only has an explanation for what's happening, he saw
it coming. His popular books "Fooled by Randomness" and "The Back
Swan" were broadsides at the risk-management models used in the
financial world and beyond.

In "The Black Swan," Taleb wrote, "The government-sponsored institution Fannie
Mae, when I look at its risks, seems to be sitting on a barrel of dynamite,
vulnerable to the slightest hiccup." Globalization, he noted, "creates interlocking
fragility." He warned that while the growth of giant banks gives the appearance of
stability, in reality, it raises the risk of a systemic collapse - "when one fails, they all
fail."

Taleb believes that our brains evolved to suit a world much simpler than
the one we now face. His writing is idiosyncratic, but he does touch on
many of the perceptual biases that distort our thinking:

1. our tendency to see data that confirm our prejudices more vividly than
data that contradict them;

2. our tendency to overvalue recent events when anticipating future
possibilities;

3. our tendency to spin concurring facts into a single causal narrative;

4. our tendency to applaud our own supposed skill in circumstances
when we've actually benefited from dumb luck.

And looking at the financial crisis, it is easy to see dozens of errors of
perception. Traders misperceived the possibility of rare events. They got
caught in social contagions and reinforced each other's risk
assessments. They failed to perceive how tightly linked global networks
can transform small events into big disasters.

Taleb is characteristically vituperative about the quantitative risk models, which try
to model something that defies modelization. He subscribes to what he calls the
tragic vision of humankind, which "believes in the existence of inherent limitations
and flaws in the way we think and act and requires an acknowledgment of this fact
as a basis for any individual and collective action." If recent events don't underline
this worldview, nothing will.

If you start thinking about our faulty perceptions, the first thing you realize is that
markets are not perfectly efficient, people are not always good guardians of their
own self-interest and there might be limited circumstances when government could
usefully slant the decision-making architecture (see "Nudge" by Thaler and Cass
Sunstein for proposals). But the second thing you realize is that government
officials are probably going to be even worse perceivers of reality than private
business types. Their information feedback mechanism is more limited, and, being
deeply politicized, they're even more likely to filter inconvenient facts.

This meltdown is not just a financial event, but also a cultural one. It's a big,
whopping reminder that the human mind is continually trying to perceive things
that aren't true, and not perceiving them takes enormous effort.
Schools and Financial Institutions Fail for
the Same Reason:
Faulty Human Behavior
"...Our brains evolved to suit a world much simpler than the one we now face.
His writing is idiosyncratic, but he does touch on many of the perceptual
biases that distort our thinking:

1. our tendency to see data that confirm our prejudices more
vividly than data that contradict them;

[We see what we want to see.]


2. our tendency to overvalue recent events when
anticipating future possibilities;


3. our tendency to spin concurring facts into a single causal
narrative;

[We find a pattern and don't see the ways in which it doesn't fit.]


4. our tendency to applaud our own supposed skill in
circumstances when we've actually benefited from dumb
luck.

And looking at the financial crisis, it is easy to see dozens of errors of
perception. Traders misperceived the possibility of rare events. They got
caught in social contagions and reinforced each other's risk assessments.
They failed to perceive how tightly linked global networks can transform small
events into big disasters.
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