Knowing and Making

A couple of times recently - notably in Bill Easterly's otherwise very positive review of Daniel Kahneman's new book - I've seen the following common critique of Nudge-style approaches: "But if people are irrational, regulators are irrational too - so how can they make rules to counter citizens' irrationality?" Easterly says: But [the case for libertarian paternalism] is much too sweeping, because it overlooks everything the rest of the book says about how the experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making... While it's right for regulators to be humble about their degree of knowledge about the world, and to be cautious in creating new regulations, there are several reasons why this particular criticism is wrong. First, we are not comparing like with like. There is no claim that a regulator, when placed in the same ...

Tony Perrottet in the NY Times suggests that writers can be more productive inside prison than out. Completely counter to rational choice theory, of course, but surprisingly plausible. I have several writing jobs to do myself, and though I haven't missed my deadlines yet, I absolutely recognise the seductive danger of twitter ( follow me !). Jonathan Franzen apparently superglued  the ethernet port on his computer to stop himself from going online. Extreme, but effective. Rationality suggests that we can never suffer from the availability of more options - because we will always choose the one that is most beneficial to us. If choice A (e.g. using the Internet) is a worse outcome than choice B (e.g. writing another 100 words) we will pick B. If we pick A, then it means that using the Internet was better for us at that moment than writing. So why did these writers deliberately stop themselves from being able to make choice A? Why can't we apply effective self-control by s...

I'm on a deadline for a magazine article today so I'm not going to write much. But a heads up on some articles coming up in the near future. I plan to write a series of analyses of individual industries from a cognitive/behavioural point of view and would welcome suggestions on which sectors to pick. Current plans are: Market research PR Accounting & auditing All of these are industries which, in a neoclassical world of pure rational preferences and perfect information, would have no reason to exist. But because the world is not like that, they do. For each one I'll be exploring which aspects of bounded rationality give the industry a reason to exist, and what this means for practitioners in the field and the way they do business. Suggestions for other sectors or disciplines you'd like me to cover? Email me or post a comment here.

For a while, I've been storing up lots of links to interesting pages from blogs and other places. I keep meaning to weave many of them into an interesting narrative, but some of them don't quite seem to fit, and yet are still on topics that I'm interested in, namely: expectations (and related, rational expectations theory) sentiment and whether it is real, and can be modelled macroeconomic theory and in particular, under what behavioural or market conditions Keynesian stimulus is efficient Here are some of those links which I'm, realistically, never going to get around to to analysing in detail: Rajiv Sethi on rational expectations and equilibrium paths . A good insight into why the rational expectations model is unlikely to reflect reality. But aren't rational expectations the only way to achieve a stable equilibrium in many models? Yes indeed. The conclusion must be that either those models are incorrect (a cop-out) or that the economy cannot be stable . Th...

Sir David Walker has been asked by the Chancellor to lead a review of corporate governance in the banking and finance sector. Sam Robbins and I, for the  Intellectual Business  think tank, have co-written a submission to this review which examines the moral hazard created by limited liability, and how bounded rationality interferes with ordinary market discipline to create risks specific to the sector. One particular conclusion is that the principal-agency problem that has supposedly led to bankers taking advantage of their innocent shareholders is nonsense. In fact, the nature of bank equity holdings specifically encourages risk-taking, and bank executives who made high-risk investments were acting precisely how their shareholders wanted them to. Interested readers are very welcome to download a copy of the document: Download Walker Review submission It's a little more dry and technical in tone than some postings here, but is intended to be quite readable. Your feedback would be ...

A note to say I'll be live blogging The Apprentice again this week. I hope to welcome back some of the two or three hundred viewers from last week and perhaps some new ones. See you at 9pm. Update : The live blog is at this link .

And finally:  See you all next week (you can of course stick around and read my normal blog in between). Subscribe using the links on the right if you want to be updated with new articles every day. Serious irrationality count this week: only 2. Surprising. I will keep a closer watch next time. 10:32  I am really not going to blog the whole of Newsnight  just to wait for Raef to come on. You can watch that yourself. 10:30  The highlight of the last half hour (apart from Anita's new slimline figure): a trailer for The Wire , starting next Monday. If you've never seen it, you must  watch. I can recommend the Guardian organgrinder blog (home of the infamous Anna Pickard) for lots of discussion of it. But watch the show first. 10:29  A very un-economic programme, You're Fired , relying on assertion and jokes to make most of its points with no numbers and no incentives to make the right choices. I think we need to rely on the real show for the hard-edged decisions. 10:28  Anita...

As regular readers know, one of the subjects of this blog is what is it to be rational: understanding how people's real behaviour departs from traditional economic notions of rationality. And as regular viewers know, there's nowhere else you'll see the displays of irrationality that show up on The Apprentice every week (for US and other overseas readers, the British edition of the show is starting tonight). So I'm going to give a running commentary on The Apprentice each episode, to point out where the contestants are irrational, to show where Sir Alan is, and to highlight ways in which an understanding of irrational behaviour would enhance the teams' chances of winning the tasks. And I'll try and have a bit of fun too. Nearly everyone on the programme is eminently mockable. Come back at 9 pm and reload every few minutes to see the latest comments. Please post your own responses too or email leigh@inon.com with your input. Let me know if it's not for public...

Lord Turner's report " A regulatory response to the banking crisis " was released yesterday. One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs. However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem. He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is n...

A fascinating question today on Robert Peston's blog which mixes rationality and game theory. Do shareholders of the merged Lloyds-HBOS want to retain the management (inherited from Lloyds) which got them to where they are today? The strictly rational answer is to look only at the future, and the expected value of retaining versus terminating the managers. Rational agents do not consider the past, as you cannot incentivise for past actions - they have already happened and there is no possibility to change them. In which case, shareholders should make a prediction about these executives' likely future performance. Of course, they do  need to use past actions and performance as data points in estimating future performance. Thus, absorbing HBOS which was probably an error of judgment, should be set against the other (generally smart) actions that they took while managing Lloyds. However, in reality people do consider the past while making these kinds of decisions, as if their cur...

According to the Sunlight Foundation , nobody (outside of the ten-person committee that negotiated it) has yet been allowed to see the stimulus bill which the House and Senate have agreed. This includes the members of the House and Senate who are supposed to vote on it today! I know that I've argued that cognitive limits and imperfect information act as a constraint on economic efficiency; and no doubt also on political efficiency. But that doesn't seem like a good reason not to publish the bill. Maybe they have slipped in that clause on a stimulus for bloggers and they want to get it passed before the twitter crowd start asking for their own version.

I attended a very interesting seminar this evening about how people evaluate (and reveal their estimates of) probabilities under conditions of ambiguity. This idea of ambiguity (or Knightian uncertainty) is very present in the economics conversation in recent months - the idea that we can't evaluate the probability of an event if we don't have reliable models, or any data to measure its past frequency. In some cases people thought their models were reliable, but they turned out not to be. In others, the key decisions were made by people without any models, relying on intuitive estimates based on the recent past. Some of the intriguing results that Peter Wakker presented today show that people respond in somewhat predictable ways to this situation. First, people tend to act as if the probability of an event is a bit closer to 50% than its real value. So, if the real probability is 75% (and even if we know that it is 75%) we will behave as if it is 69%, or 61%. The amount of bia...

I've had an article published today in VoxEU: Models of bounded rationality and the credit environment : Responses to the recession should not be based on unrealistic expectations of rational behaviour. We now know enough about real, flawed human psychology to be able to take some account of it in policy setting. Mark Thoma has linked to it and there are some interesting responses in the comments to his posting.