Business Insight Zone

Though I’m verrrrry much an amateur at it, behavioral economics has been a fascination of mine for a little while. Here are two current stories, one by the eminent behavioral economist Robert Shiller of Yale, the other overtly about the prevailing logic of poor people, but with a distinct behavioral-economics bent.

First, Shiller in the New York Times:

A Psychology Lesson From the Markets

. . . Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

. . .

People worry that they must increase their wealth to fend for themselves. One might think that this lack of trust would promote much precautionary saving, but world savings rates are not high over all. It has generally fit in better with popular perceptions of the booms to be smart investors, not great savers.

. . .

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

This article isn’t the best thing Shiller has ever written, and it doesn’t make for a great primer in behavioral economics. But it is useful for pointing out some of the steps of (il)logic that people use to drive their actions in unusual market environments — or in ordinary market environments that are misperceived.

Next we turn to a Steven Pearlstein from the Washington Post:

On Poverty, Maybe We’re All Wrong

. . . The reason the poor are poor is that they are more likely to not finish school, not work, not save, and get hooked on drugs and alcohol and run afoul of the law. Liberals tend to blame it on history (slavery) or lack of opportunity (poor schools, discrimination), while conservatives blame government (welfare) and personal failings (lack of discipline), but both sides agree that these behaviors are so contrary to self-interest that they must be irrational.

After all, the reason we study, work, save and generally behave ourselves is that these behaviors allow us to earn more money, and more money will improve our lives. And, by logic, that must be particularly true of the poor, for whom each extra dollar to be earned or saved for a rainy day is surely more valuable than it is for, say, Bill Gates.

In economics, this insight — that the fifth ice cream sundae is less valuable than the first one — is enshrined in the law of diminishing marginal utility.

But what if this iron law of economics is wrong? What if it doesn’t apply at every point along the income scale? If you and everyone around you are desperately poor, maybe it’s perfectly rational to think that an extra dollar or two won’t make much of a difference in reducing your misery. Or that you won’t be able to “study” your way out of the ghetto. Or that if you find a $100 bill on the street, maybe it’s logical to blow it on one great night on the town rather than portion it out a dollar a day for 100 days.

On the other hand, maybe the point at which people are most willing to work hard, save and play by the rules isn’t when they are very poor, or very rich, but in the neighborhoods on either side of the point you might call economic sufficiency — a motivational sweet spot that, in statistical terms, might be defined as between 50 percent ($24,000) and 200 percent ($96,000) of median household income.

As Pearlstein himself points out, this is just one theory for what is happening with poverty in the US. But it seems to comport with my own observations, not about financial markets, but about people. We do seemingly irrational things all the time, based on elements of logic that don’t (always) reduce to numerical considerations of money. Any classical economist would admit this off the record, but it is the behavioral economists who have made it their business to figure out what these other considerations are.

In my view of the world, all of this ties back into our perceptions of which phenomena are the (transient) “weather” of our lives and which are the (durable) “landscape.” Our sometimes “illogical” mindsets on these issues lead to the sort of broad miscalculations that we are now seeing play out in the subprime mortgage market.

Category: Economics