TH has been taking some time with friends and family and not much else except a spot of reading over the last little while. He has been trying to read the book – Thinking, Fast and Slow – by Daniel Kahneman that he started back last Christmas. It is a neat book that is filled with examples of how quick and intuitive reasoning generates all sorts of biases. So far, there are two things that I think economists should get from the book. The first is that it teaches us about how policy makers think – especially at times of crisis and great uncertainty, when quick intuitive decisions are called for. Understanding the systematic biases in their decisions is important if we want to understand why they are doing what they are doing and the implications of their actions (TH has written about this before). Second, TH reckons you can learn a bit about how we have collectively overcome some of our inherent flaws through the power of the markets – instead of being a challenge to the economic model, the book helps us to understand better why markets have evolved and what a wonderful job they do.
Apparently Torrens wasn’t the only one reading it. Conversations with friends revealed that the material in Kahneman’s book is making good material for workshops and seminars, as well as the talking head “experts” on radio and TV who want to chastise other experts for their biased reasoning – oh the sensation of it all.
TH hasn’t finished the book yet, but he is starting to understand why it’s getting all that attention. First, Kahneman is not the first to write a book on the subject – there are a few out there – Predictably Irrational by Dan Ariely jumps to mind (which TH is also halfway through). This means that the market has been broken in a bit by the other writers and there is a bit of a band wagon effect creating an “availability cascade” as Kahneman might call it. Second, Kahneman won the Noble prize in Economics (back in 2002) for his work that challenged the economic model of rational decision making, so it is no surprise that at a time when the global economy has gone so awry, people look to the insight of scholars like Kaheman for insight.
The book is good. Kahneman writes clearly and “intuively”. He uses plenty of simple examples that help us to understand how we think and how intuitive reasoning can lead us into dreadful mistakes. That said though, TH is starting to get a bit worn down by the book – to be blunt, he seems to get it already. Individuals have small brains not massive super-computers and the world is a complex place. To get through life we rely on a quick working portion of our brain that generates rules of thumb, which is frequently wrong, or biased, but saves a lot of energy, effort and time. This is especially true for reasoning that requires statistical analysis, which our brains seem to have most trouble with.
And then there is the point that financial analysts and people like us are incapable of making money through stocks. This all makes TH wonder, how does the economy function at all? After all, as TH likes to continuously stress, the economy is not an entity to itself, it is just a big bunch of people like us all constantly making decisions and frequently, it seems, consistently wrong ones.
TH reckons the answer can be found in Adam Smith, one of the founders of modern economic thought, in his theory on the division of labour and the gains from specialisation. As any first year economics student should know, the economy is made up of people who specialise in tasks. Just think, what is your current job? TH is certain that you are not a psychologist and a police officer and a nurse and a window washer (though mums might disagree). You might be one of these – specialising and thinking deeply about things related to your work, so that the rest of us don’t have to. Sometimes you might even offer intuitive advice to others on matters related to your work, for which you get paid. That is, you give others a simple “intuitive” story that seems plausible and can be readily summoned and used quickly when they need to. In other words, while we might individually be prone to bias, collectively we find ways around the biases by relying on people who think deeply. And, even if these deep thinkers also make mistakes, hopefully they are not as bad as the ones we make individually.
The other aspect of the answer is competition. At one point in the book Kahneman goes out of his way to argue that financial market analysts are essentially worthless. He seems to be arguing that you may as well have a bunch of monkeys picking stocks, because you can do no better than the market. In a way, he is right, you can’t do better than the market; you may as well hold the market portfolio (buy the index) rather than trade. The reason that the return is equal to the “market” return is competition. Competition drives the profit from trying to pick stocks to zero. By profit we mean economic profit – you can make some money by picking stocks, but just enough to cover your costs from doing it.
OK, so perhaps it is a waste of time for someone at the margin to pick stocks. But here is a different question. What if we replaced all those market analysts with monkeys, would the market be efficient? Would it even work? What Kahneman has failed to acknowledge and explain is how all those financial analysts work to collect, think about and synthesise all that information about the tens of thousands of firms in the economy and then allocate credit to them. As a result these firms receive the funding they need to create jobs and wealth, to create new technology and innovate; and fund your favourite restaurant or café and even publish books like Kahneman’s. While there are examples of how he credit may have been misallocated (no better exemplified by the global financial crisis), generally financial market analysts do a good job. Whatsmore, the information they gather produces a most remarkable public good – the price of credit and stocks, which generally convey most of the relevant information that markets need. It is really a most remarkable phenomenon, and Torrens was disheartened that a Nobel Prize winner in Economics could not see the value that is created even if the economic profit from financial analysts efforts does get driven to zero.
In sum, what you can take away from all this is that despite our logical failings it is a wonderful world.