In Defense of Rational Decision-Making

Considering how long the Enlightenment has been around, we should not still be debating whether or not human beings can be trusted to behave rationally. Yet, we are.

If you believe that we humans are fundamentally greedy, and that we are motivated by our wish to accumulate as much as we can regardless of the consequences, then you would side with those who believe that our irrational or visceral motives will always outweigh our rational faculties. For some of my earlier comments, see here.

When markets crash, those who believe in the power of irrational impulses feel vindicated. According to their theories, the crash was an inevitable manifestation of a natural human propensity, one which, left unchecked and unregulated, must inevitably lead to disaster.

In the long run, these theories would have it, we simply cannot be trusted even to do what is best for ourselves. And why, if that is true, should be trusted to do what is right for others?

Richard McKenzie offers an interesting rejoinder in his article, "Predictably Irrational or Predictably Rational." Link here.

In his words: "Indeed, behavioralists have discovered so many decision-making biases and flaws, resulting in so many documented 'irrationalities' among their varied human subjects that one has to wonder why they believe themselves capable of writing rationally on the subject of peoples' irrationalities."

This comment makes an interesting point. Just as psychoanalysts insist that they are prey to the same impulses that torment the rest of humanity they also believe that, by dint of their superior insight, they are better able to control the impulses and thus are qualified to judge everyone else who lacks the same wisdom.

Anyway, ideas have consequences. And if we cannot be trusted, then we need be be regulated, even nudged and pushed in the right direction. Left to our own devices, we will become greedy and rapacious; thus we need a higher authority or a more powerful institution to set us on the right path.

So, it makes sense that behavioral economists who believe in the power of irrational and visceral motives would also believe that markets need to be regulated and controlled by government. As George Akerloff wrote: "We assert the necessity of an active government role in economic policymaking.... we know that managing ... animal spirits requires the steady hand of government." Link here. Via Simoleon Sense.

While there is always a role for government as referee, it is quite something else to call for the steady hand of government. And isn't this notion of an active government hand in all economic transactions strangely familiar: doesn't it echo the notion that given our propensity to sin we cannot be trusted to conduct our personal lives without the steady and very visible hand of a church?

If you follow McKenzie and ask how those who regulate the markets can be trusted to control their own visceral impulses, the answer must lie in the fact that they are wiser and more clear-headed because they are not burdened with the profit motive. Thus, they will be less prey to greed. The same would apply to tenured academic economists.

Similar reasoning defines Freudian psychoanalysis. For Freud, the power of instinctual and self-destructive tendencies, coupled with the influence of trauma and inadequate parenting, made it impossible for those who had not undergone psychoanalysis to make good choices in life. Absent a journey on the couch, they would be condemned to repeat the miseries of the past.

Thus, Freudian treatment could not begin with the concept that people can be trusted to make good and right decisions. At its inception it prohibited people from making life decisions while in treatment.

Obviously, psychoanalysis does not call for expanded government control of the economy. At the least it calls for a transformation of the culture to make it more tolerant of those who are prey to their visceral impulses and animal spirits.

Clinically, psychoanalysis wants the patient to get in touch with his visceral or instinctual wishes, the better to be aware of their influence and the better to rein them in.

None of this has ever taught anyone how best to make decisions. You cannot learn how to make decisions unless you make decisions. If you learn that what matters in your decision-making is whether or not your decisions repeat or enact an irrational impulse, you will cut yourself off from any reality that might tell you whether your decision was right or wrong.

In some economic theories this reality is the market. If the market passes judgment on your decisions, McKenzie believes that it encourages rationality and better reflects the truth of human character than do laboratory experiments.

In his words: "Indeed, markets do far more than induce improved allocation of resources, given wants and resources. Markets induce market participants to be more rational than they otherwise would be because they must pay a price for being irrational."

If you want to believe that people are viscerally inclined to do the wrong thing, then you either become a proponent of increased regulation or a control freak. You might easily decide that other people in your life cannot be trusted to do the right thing, thus, that you need to keep them on a very short leash indeed.

In my coaching practice it often happens that clients insist that their friends, neighbors, children, and significant others are incapable to doing the right thing. From there they rationalize all manner of criticism and coercion.

This assumes that said individuals are not to be trusted,and at times, are not even allowed to fail.

Worse yet, people who cannot be trusted are also not being respected.

But what happens when you are one of those who is not respected as a rational and responsible human being, but who is demeaned for being prey to your animal spirits and visceral impulses?

Under those circumstances you would probably feel disconnected and detached from human community, alienated from your moral being. However your inner moral sense might be telling you otherwise, you would feel forced to go out and get what you want when and how you can.

Will the Animal Spirits Eat the Green Shoots?

In today's Financial Times Christia Freeland declares that the government has revived the nation's animal spirits by successfully managing the public mood. Link here.

After reading her article I recommend a chaser: Paul Krugman's column in today's New York Times. Krugman paints a rather more sober picture. Link here. (Also check out Doug Kass's analysis of financial stocks. Link here.)

Where Freeland sees the burgeoning green shoots as a harbinger of spring, Krugman tells us to be very, very afraid.

He fears that Wall Street is getting ready to go back to business as usual, as though nothing really happened. Our animal spirits have simply recovered too quickly... and that is not a good sign.

To mix two metaphors, Krugman is predicting that our hungry animal spirits are going to eat the economy's green shoots.

It makes good sense, from a contrarian point of view. If everyone is feeling as good as Freeland says they are, wouldn't a believer in contrary sentiment take that as an indicator that trouble lies ahead and that we should be very, very afraid?

Richard Posner on "Animal Spirits"

Judge Richard Posner has just weighed in on the topic of "animal spirits." As always, his remarks are worthy of serious attention. Link here.

For my own posts on the topic, link here.

Posner begins by turning the tables on the economists who are worrying about the psychology of market participants.

He notes that the current crisis must be a great embarrassment for economists.

Economists who studied the Great Depression assured us that it would ever happen again. They expressed full confidence in their own abilities to avoid the mistakes of the past.

Which is well and good, except that that does not guarantee against making new mistakes.

Ask yourself this: how many people based their investment decisions on the premise that our brilliant economists could guarantee that there would never again be a Great Depression?

It reminds me of therapists who pretend that if their patients discover why they got it wrong in the past then they will naturally get it right in the future.

I have often argued that this is a fundamental mistake, not least because knowing why you got it wrong does not tell you how to get it right. It tells you want not to do, not what to do.

For all of their knowledge of the past, economists were at a loss when the banking crisis hit. Not knowing what to do, they decided to do everything.

In Posner's words: "Academic and government economists specializing in the business cycle were as surprised by the September collapse and the ensuing downward spiral of the economy as anyone, and were unprepared with plans for arresting it. Six months later they cannot agree on what should be done to recover from it. Not knowing what will work, the government is trying everything."

Eight decades of study by some of the greatest minds in the world did not lead to a consensus. The great economists do not agree on what worked in the past.

Some believe that fiscal policy (increased government spending) is the solution; others place their faith entirely on monetary policy (lower interest rates.)

Some believe that the New Deal rescued us from the Depression; others believe that the New Deal aggravated the problem.

Like a mind divided against itself, the government has decided to try it all, all at once.

But this approach bespeaks panic and sows doubt. Why would anyone feel confident in the future when our leaders are reacting our of fear.

Add to that the fact that the new administration seems more intent on paying off the special interests that gave them power than fixing the banking system.

Telling us that clean energy and universal health care will solve the financial crisis is inane. It ranks up there with the notion that giving new powers to labor unions will impel businesses to hire more workers.

But then again, the Obama administration seems more intent on fixing the blame than on solving the problem.

Does the administration grasp the problem and does it have any real confidence in its ability to solve it? Or does it believe that free market capitalism is the problem and that increased government control over the economy is the solution?

To repeat a point I have made before, the real question is not whether the administration believes in free markets, but whether the markets believe in the administration.

As of now, the answer is that they do not.

Posner described the Obama administration this way: "The intentions are good. But the lack of focus, the partisan squabbling, the dizzying policy oscillations, the delays in execution, and the harassment of bankers are bad."

The markets probably suspect that this administration is more interested in election victories than in economic growth, and, thus far, they have been acting accordingly.

Is It Ethical to Go John Galt?

The concept of "going John Galt" has been denounced for being amoral and selfish. Its detractors believe that if you work at less than your optimal capacity you are subverting the economic and social order.

The argument leads to an absurdity. As Dr. Helen Smith explained: "It strikes me as odd that if you work and make money, you're a selfish bastard, and if you stop working hard and making money, you're a selfish bastard."

The detractors assume that your work does not belong to you. If that is true, then someone else, a bureaucrat, has the right to force you to do what he wants you to do.

But then no one can say that you are responsible for your actions. Coercion removes personal responsibility.

Under such a regime, the only way to exercise your freedom is to work less. When taxes become so onerous that you are working mostly for the state, the only way to exercise freedom is to go on vacation.

Some have criticized "going John Galt" by conjuring dramatic images of physicians going on strike and leaving their patients to die.

Of course, that is not the point. It's not about the strike, but about the extra effort that might make the difference between finding or not finding the correct diagnosis.

When a physician earns a fixed salary no matter how hard he works, he is going to be less present when he is needed. Not so much because he has decided to become a slacker, but because his extra effort has not been appreciated.

Perhaps this is why patients in government-run health care systems must wait so long to receive needed treatment. Even with the best of intentions, when physicians have lost their freedom to earn as much as they can, their morale will be undermined and they will work less effectively.

It all goes back to "animal spirits." In times of deflation and depression how can we motivate people to work harder, to spend more money, to invest in productive enterprise, and to loan out money.

According to the concept of "going John Galt" granting them more freedom-- not more regulation-- is the key. They will be more likely to put their capital to work if they are free to take risks... to enjoy the benefits or to suffer the losses.

And this does not just apply to investment capital or human capital. It also applies to psychological capital, the self-respect that is gained or lost through social interaction.

It's all about competition. Competitive games need to be fair. They should afford everyone an opportunity to engage their energies. But they never yield equal outcomes. If the game is rigged, then there is no reason to play. And, when nothing is to be gained-- in money or self-respect-- a rational actor will naturally not engage.

The problem is not so much that people are going to go on strike. More insidiously, excessive taxation and regulation will cause people to work less effectively, to lose focus, to be more distracted, to take more time off, and to seek out more leisure.

No one is going to take very many risks or to invest very much effort if he is not allowed to enjoy the rewards.

Animal Spirits, Part 4

Robert Shiller's new book, "Animal Spirits," is out, and he has used the occasion to offer some more thoughts about the economic crisis. Link here.

Following Keynes, Shiller states that since investors cannot know with certainty the return on their investments, they are basing their decisions, not on rational calculations, but on animal spirits. To which Shiller adds, on stories.

In a poorly written sentence Shiller explains: "People's economic moods are largely based on the stories people tell themselves and tell each other that are related to the economy."

The tech bubble was kept inflated because people wanted to live the stories of dotcom millionaires. Then they wanted to live the stories of house flippers. Then they rushed into the securitized mortgage market because smart people were getting rich there.

Surely, some people live their lives as though they were stories. Often these end badly.

But that does not mean that stories are a primary motivating factor in human behavior. It means that some people some times allow themselves to get caught up in irrational exuberance.

Paradoxically, people are drawn to live out stories because the outcome is predetermined. Nothing you do can change the ending of the movie you are going to watch tonight. Seeing life within the context of a story allows you to imagine that you can remove all uncertainty.

Markets, however, do not function as stories. They function as games.

People play games because they want to compete and participate, and because they believe they can succeed. People drove up the prices of tech stocks because that was the biggest game in town at the time. Idem for mortgage backed securities.

Everyone wants to be actively involved in games; they are not primarily motivated by a wish to make themselves into living fiction.

Games and stories differ fundamentally. The outcome of tomorrow's ballgame is not predetermined... or, shall I say, it had best not be. With a game, when you cheer or jeer from the stands, you are trying to influence an indeterminate outcome. You are part of the team, not an actor in a drama.

Let us correct Shiller, and say that free enterprise is a game. Government has a place in this game, as an umpire and a referee. Government does not counterbalance a human tendency to pillage; it allows human beings to play the game the way they want it to be played, fairly and justly.

Attacks on unfettered free market capitalism are attacks on a straw man. There is no such thing as a market where there are no rules and no enforcement of the rules and no one entrusted to ensure fairness.

The issue is whether government can encourage everyone to play by the rules, or whether it wants to determine the outcomes. Because, after all, some outcomes make for better stories.

When the government tilts the game in one direction or even decides that it must determine the outcome, smart people will withdraw from the game.

They do not want to expend their animal spirits on a game that is rigged, that has been turned into a story with a predetermined ending.

Of course, rigging the game is not merely the province of government. Government can also sit by and allow others to tilt the playing field to their advantage.

Recently, too many people decided that they could leverage their bets to an absurd level because they believed that the game was rigged and the fix was in.

If you believe that the game is rigged, and you believe you are betting on a sure winner, then you will happily bet your house on the outcome. Isn't that what happened to the financial system.

The system was not rigged by crooks and thieves, but by people who suffered hubris about their own genius. Brilliant minds decided that the game was being controlled by invisible forces, and that they were smart enough to figure out the outcome in advance.

Thus, they could confidently bet their houses, and our houses too.

So, stories can motivate people, but only at the extremes, when they believe that the game has been fixed.

If there was an unseemly rush into the markets because too many people believed that they could never fail, now there seems to be a rush to the exits because many people believe that with the government picking winners and losers, there is no way to ensure that the game is going to be played fairly.

Animal Spirits, Part 3

"Once more unto the breach, dear friends...."

That's Shakespearean for: here I go again with animal spirits.

The nation is debating how best to revive the animal spirits that will drive us to shop and spend, thus saving us from the ravages of deflation.

Today, the estimable Jim Jubak offers his opinion that the New Deal did work, up to a point, but that it did not work as well as World War II. The latter really rescued us from the Depression because it provided the economy with a gargantuan level of stimulus. Link here.

That fiscal stimulus gave the economy a real and sustainable boost. More than that, Jubak declares, surprisingly, that the wartime stimulus produced economic growth for decades to come. "The momentum built up by the war years carried the economy for decades."

So, the best way to revive our animal spirits is the throw enormous amounts of money at them. This presupposes that we must always respond to fiscal stimulus-- a rather simplified view of human motivation.

So, I want to offer some simple observations, to show that, socioculturally speaking, there is more to warfare than fiscal stimulus.

First, the war did eliminate unemployment, through the miracle of conscription. And surely chronic, intractable unemployment made the option of a job with the military desirable.

Second, the war did not immediately revive consumer spending, mostly because it imposed strict rationing. Perhaps the years of limited consumption created pent-up demand, but you cannot credit the war with reviving those animal spirits.

Third, the war brought us together as a nation. It united the populace by giving everyone's daily activity a sense of overarching purpose. During the war, no one was running around asking: "What about my needs?"

Fourth, the war succeed eight years of depression. Was it because of the protracted depression that everyone was more than willing to engage in the war effort?

Fifth, the war restored a spirit of cooperation and competition. We forged alliances with our allies and competed in a struggle to the death against our enemies. Competition in a high-risk environment always tends to focus the mind.

Sixth, wars center the nation around the military. It makes soldiers, not celebrities, into heroes and fosters admiration for a social organization that has strict rules and roles, where everyone knows his or her place, and his or her duty.

Seventh, during the war civic virtues ruled. The war built character. During a war people identify with their nation. There are no citizens of the world during a war. Values like patriotism, loyalty, duty, responsibility, and obedience were elevated while values that involved self-indulgent complaining were reduced.

Eighth, we won. The nation won the war. And victory, especially victory against long odds, fosters confidence. Moreover, it was a victory for the nation, not for a leader or a party.

Ninth, success breeds success. The work habits, the good character, the patriotism and loyalty that had been inculcated during the war did not go away after the war. They were transferred into other economic activity.

If you are looking for what drives the "animal spirits," these sociocultural factors may also claim pride of place.

Animal Spirits, Part 2

When last we looked, our greatest economists were out in the woods beating their drums in a vain attempt to revive our animal spirits. (See my post of January 30.)

They want us all to buy and invest, the better to forestall the movement toward deflation and depression. Their theory says that we are not doing so because we have become traumatized into economic inactivity. Their solution: we need to get in touch with our animal spirits.

As I said, I am not sure why, beyond their love of Keynes, they need to evoke animal spirits. When animals are threatened, they can choose between fighting, fleeing, or playing dead.

By assuming that our animal spirits will provoke the right kinds of actions, Keynes and Co. has confused the issue. Evoking animal spirits does not tell us what we should do.

There is no reason to believe that animal spirits are more likely to tell us to run out to Walmart than to lounge around the house in pajamas.

Besides, when trauma victims follow their urges, they most often act in ways that make the problem worse.

Last Friday the Wall Street Journal ran op-ed by Peter Berkowitz that cogently corrects the argument from "animal spirits." Link here.

According to Berkowitz, we are having trouble dealing with the crisis because our political culture has become a breeding ground for immoderate passions, to the detriment of free and rational decision-making.

We are so overwhelmed by passions, so caught up in myths... that we are simply not thinking straight any more.

As Berkowitz put it, a large segment of our political culture glorifies the irrational and makes intense emotion the gauge of truth. Such a culture can only hinder our ability to make rational choices and to do the right thing.

The intemperate passions, as Berkowitz sees it, involve the deranged hatred that certain segments of the population visited on George Bush, and the irrational exuberance these same people are now showing for Barack Obama.

It is as though a clan were sacrificing a person who has been scapegoated as the cause of all ill, and then worshipping another figure as a tutelary animal spirit, a totem.

This is primitivism run wild. Unfortunately, as Berkowitz shows, our media gurus and educators have been teaching us that the stronger our emotions, the closer we are to the truth.

As Berkowitz puts it, they have taught us that "hatred and euphoria reflect political wisdom."

If the way out of the crisis requires rational thought and free choice, then we should not be encouraged to see large segments of the population transformed into cult followers who think that their excessive passion makes them enlightened.

Grand passions may inhibit actions, but they most often incite people to do the wrong thing. Especially when they tell people to obey their urges.

Overcoming trauma, as Berkowitz suggests, means learning how to exercise freedom. If a trauma victim allows the trauma to define what he can or cannot do, whom he can or cannot see, where he can or cannot go, then the trauma has limited his freedom.

To exit that mindset the victim must decide to take actions that run counter to what his emotions and his urges are telling him. And he must trust his rational faculty enough to act accordingly.

A culture that is based on emotional excess prevents us from acting rationally and freely because it promotes magical thinking and tells us that we should trust animal spirits.

When people believe that they have eliminated the scapegoat that has caused them pain and have found a redeemer who will deliver them from evil, they will think that they have done all they need to do. Now they just need to sit back and await redemption.

Deprived of their reason and their freedom, they can only hope that the animal spirits will carry them away.

Animal Spirits

You know we're in trouble when the greatest economists agree that the solution to the current financial crisis involves: "animal spirits."

These thinkers activated their sky-high IQs, crunched the data, applied some analysis, and seemed to suggest that we really need... a shaman. Who would be more qualified to channel our animal spirits?

The eminent Yale economist Robert Shiller write this week in the Wall Street Journal that we need even more fiscal stimulus than the president has proposed because that is the only way to awaken what John Maynard Keynes famously called our "animal spirits." Link here.

To which Harvard economist Gregory Mankiw replied: "The sad truth is that we economists don't know very much about what drives the animal spirits of economic participants. Until we figure it out, it is best to be suspicious of any policy whose benefits are supposed to work through the amorphous channel of 'confidence.'" Link here.

Dare I remark here that even if economists do not know what drives people to act, other professionals-- managers, leaders, and coaches-- do know something about the topic.

Be that as it may, I would recommend that these economists would do well to indulge some straight thought. After all, invoking animal spirits here just feels like a cop out. Are these great thinkers telling us that we need to go out and find our totem? Perhaps a little conceptual rigor would do them well.

I doubt that they are going to be able to think us out of the current morass with a lame concept like "animal spirits."

To be fair, Keynes defined the concept, thusly: "human decisions affecting the future... cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist... it is our innate urge to activity that makes the wheel go round."

So, "animal spirits" is shorthand for an innate, seemingly irrational, urge to act. Keynes is suggesting that since we cannot make a strict calculation about the future, we act on impulse and instinct, more than on reason.

Think about this concept and it begins to feel like a pagan version of a leap of faith.

And the concept fails for being too general. What kind of animal are we talking about, specifically? Does Keynes want us to get in touch with our inner rat-ness or our innate snakehood. Has he considered that when bears hibernate they are evincing an innate urge toward inactivity.

Usually, when the term "animal" is applied this generally to a human being, it is derogatory and demeaning. If you telling someone that he is acting like an animal you are not paying him a compliment.

Could it be that economists evoke "animal spirits" to describe human behavior that does not fit their models and to slander the humans who do not act as the economists think they should?

Another problem is simple enough. What makes you think that these urges to activity are beyond calculation and even reason. Don't people calculate risk and probability to decide on future actions?

Does anyone really believe that animals are driven by irrational impulses? When a hungry lioness chases a gazelle, she is impelled by a perfectly intelligible motive. We do not know her analysis of risk and reward, but her behavior can certainly be understood within such parameters.

In truth, a human being is far more likely to have an irrational attitude toward nutrition than any other member of the animal kingdom.

But now, what are we to make of Robert Shiller, author of a forthcoming book on "animal spirits," when he takes the concept of an "innate urge to activity" and transforms it into concepts of trust and confidence?

According to Shiller, waning animal spirits cause a loss of "consumer trust and confidence." We have also lost a sense of trust in each other and our sense of fairness.

Whatever does that have to do with animal spirits? Perhaps you trust your dog-- I hope you do-- but you would certainly not trust a hyena. The next time you encounter a bear in the woods you will probably not be thinking about confidence-building measures.

Or, imagine a band of vultures congregating around a water buffalo carcass. The carcass is being torn apart by a pride or lions or a troop of hyenas, and the vultures are waiting their turn. Are they doing so because they trust the larger predators to leave them some table scraps?

Surely, we need to restore trust and confidence in our financial system. We need to restore trust and confidence in our government too. But have the smartest economists in the world really helped us out when they say that it is all a matter of mobilizing our animal spirits?

Perhaps if they adopted a more coherent concept they would have a better grasp on what makes people behave and misbehave.

If they insist on being Keynsians, they should at least acknowledge that this is the Year of the Ox. Can you think of an animal less known, in Keynes's words, for "a spontaneous urge to action rather than inaction?"