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Are we stupid?

• Evan Davis | Notes on Real Life |
• 19 Mar 08, 11:12 AM

As we sit in the midst of what seems like an historic episode I find myself struck by one question: how can we have let ourselves get into this again?

Didn’t we know this might happen?

At least we should have seen a turn in the housing market coming, surely? It’s not just in the UK that we have had several years of warnings of house price corrections, comparisons to the 1980s, graphs showing scary upward trajectories.

Yet some of the world’s best paid people lent money secured against inflated house prices, and appear to be surprised that the market is not what it was.

There’s a ±«Óătvr Simpson quality to the analysis that led us here…you can picture ±«Óătvr attempting to grab a donut well out of his reach, banging his head, and then repeating the mistake time after time. That’s where we appear to be in the housing market.

One colleague suggested to me today – rather acutely - that housing market cycles last eleven years, while our memories last nine. There is always a two year silly frenzy that has to be undone.

The idea is not very different to that expressed by Alan Greenspan in . He bemoaned the obvious failure of the commonly used risk-management and econometric models to cope with the episode we are now in.

They do not fully capture “the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve” he wrote.

It’s probably the only point on which and would agree.

Interestingly, human irrationality is a hot topic in economics at the moment. it’s called, on the cusp of economics and psychology.

While it is dismissed by some old-school economists as a bit flaky, and by others as intellectually lazy, it is a subject that is hard to dismiss entirely, particularly as we look at the repeated cycles of boom and bust.

Put simply, behavioural economics argues that human beings’ decision-taking is guided by the evolutionary baggage which we bring with us to the present day.

Evolution has made us rational to a point, but not perfectly so. It has given us emotions, for example, which programme us to override our rational brain and act more instinctively.

Those emotions probably worked well for us in the savannah, where it wasn’t really very useful to spend time thinking about whether to flee the tiger or not. But the instinct is still with us now, it affects our behaviour, even that of apparently very rational people, and it can’t be ignored.

Emotions are just one example of behavioural effects. The general point is in explaining our behaviour, evolution can trump economic theory.

Two current books make the case for taking behavioural economics seriously rather well.

The first is which details the many experiments that have been performed on people to demonstrate systematic behavioural traits.

The second – released soon – is Basic Instincts, by Peter Lunn. It is an excellent book; a feistier defence of behavioural economics and more of an attack on traditional economics.

Personally, I don’t see old economics and behavioural economics as opposed. It is useful to assume people are rational as a good approximation to their long term behaviour, but it would be unwise not to think how in practice their behaviour may deviate from that simplifying assumption.

Both books are well worth reading.

You will read about fascinating lab tests on people, demonstrating the ways in which honest people allow themselves to be dishonest, about how sexual arousal affects judgement and how we tend to work less hard if we are paid by results, than if we are doing something as a favour for someone.

And talking to Dan Ariely in recent days, I find he comes up with at least two ways in which the literature is relevant to where we are now.

First is the insight that emotion (greed, fear) can override rationality when we make decisions (we repeatedly tend to buy too much food if we visit the supermarket when we are hungry).

And secondly is a tendency to see evidence selectively. We give more weight to the facts that support the theory we have in mind.

So in the upswing, it is easy to find facts to support the upswing…other evidence is overlooked. Only when the countervailing evidence becomes unarguable, do we change our mindset and start fearing the uncertain.

The literature does not imply we’re stupid. We’re just not as clever as we like to think.

It is a good point to bow out on, as this column represents the last post for the Evanomics blog for the time being.

I stop being Economics Editor this week, as the excellent Stephanie Flanders takes over. (I’m not sure if it be called Stephanomics, but her blog will be worth reading whatever the name.)

I will strive to do some writing, but my new day job (or night time job to be more accurate) will be presenting the Today programme on Radio 4 (for a year at least).

It’ll be a fascinating test, to see whether the mind-set of an economist can contribute to discussions on subjects as diverse as Pakistan and frog spawn.

Thank you for reading Evanomics, and to the News blogs team for ensuring that some of the most egregious errors are dealt with.

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