Pursuit of Truthiness

my gut tells me I know economics

The Wisdom of the Crowds in Your Head: The Case of Behavioral Finance

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A common idea in the social sciences is that two wrongs can make a right, when errors cancel each other out.  So we have the Median Voter theorem, the Efficient Market Hypothesis, the Wisdom of Crowds.

Some aspiring rationalists have worried that the same process takes place not only in large groups of people, but within the head of a single individual.

Why worry about this?  It would mean that correcting for a single bias could bring you further from the truth, by leaving a corresponding bias in the opposite direction unchecked.

This precise thing seems to have happened with behavioral finance.  In the post that started the Great Macro Flame War, Paul Krugman said that the study of behavioral finance should be a major part of the future agenda for macroeconomics.  But Brad Delong, Krugman’s ally in this debate and in general, recently admitted in “Recent Economic Thought as an Interrupted Three-Cornered Cage Match” that it was behavioral finance that led him astray and prevented him from seeing the oncoming crisis.  He says on page 8 that “it did not seem to be such a bad thing to raise the market’s risk tolerance- the behavioral financiers like Richard Thaler and Matthew Rabin tell me that investors are, by and large, much too fearful”.  Now, of course, it does seem like a pretty bad thing.  There were biases in the other direction that were not corrected for, especially the low capital ratios of major Wall Street investment banks.

I suppose there are two lessons from this.  First, behavioral finance is not going to solve all the problems of macroeconomics any time soon.  Second, when making a change to a complex system- like your beliefs, or the economy- one must consider all the possible effects.  An economist thinking along these lines may have been able to save the day by preventing the SEC from removing capital requirements on the shadow banking system in 2004, though in this case political failures would probably have overwhelmed better economics anyway.

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Written by James Bailey

September 29, 2009 at 10:02 pm

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