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Bringing Behavioral Science to Economics

By Ronda Muir

pDavid Brooks' editorial in the October 28, 2008 emNew York Times/em predicted that the currentnbsp;financial crisis would quot;amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy.quot;nbsp; Of the four steps of decision-making--1) perceiving a situation, 2) thinking of possible courses of action, 3) calculating the best course, and 4) taking action, Brooks notes that the third step--rationally calculating and maximizing what is in the best interests of those involved--has long been considered the most important.nbsp; But he suggests that comments by quot;expertsquot; like Alan Greenspan in hisnbsp;testimony before Congress, that he was quot;shockedquot; at market conditions, may drive us tonbsp;reevaluate the importance of step one:nbsp; perceiving the situation./p pIn Nassim Nicholas Taleb's book quot;The Black Swan,quot; published in 2007, he wrote that quot;The government-sponsored institution Fannie Mae, whennbsp;I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable tonbsp;the slightest hiccup.quot;nbsp; Globalization, he noted, quot;creates interlocking fragility,quot; and the growth of giant banks give thenbsp;appearance of stability, while in reality, they raise the risk of a systemic collapse, fornbsp;quot;when one fails, all fail.quot;nbsp; But why didn't the financial movers and shakers perceive that to be the case?nbsp; Or even one possible case?/p pBehavioral economists have explanations for why so many smart people could have been so wrong about the risks that they were unwittingly taking.nbsp; Biases in our perception that distort our thinking include a tendency to see data that confirm our prejudices, a tendency to overvalue recent events as predictors, assigning a single causal narrative to coincidentally succeeding facts and applaudingnbsp;what wenbsp;suppose to be our skillnbsp;rather thannbsp;recognizing the role ofnbsp;dumb luck.nbsp; And we can also get caught in social contagions that reinforce each other's (often poor) risk assessments.nbsp;/p pThe solution that some propose for the financial arena is to have the government take on more of the job of assessing situations, and applying regulations.nbsp; Of course, government officials are probably going to be even worse perceivers of reality than private business types.nbsp; Their information feedback mechanism is more limited and, being deeply politicized, they're even more likely to filter out inconvenient facts.nbsp;/p pLawyers, being for the most part pessimists, would seem to have the exact skill necessary to root out andnbsp;protect againstnbsp;just this sort of unintended economic consequence.nbsp; Lawyers should be able to think of all the possible ways these various financial scenarios could go wrong, and at least sound the alarm if not plug the hole.nbsp; But the critical word here may be quot;think.quot;/p pOur data on emotional intelligence in lawyers tells us that, when it comes to emotion, perceiving--correctly identifying the emotional currents at play--is what lawyers arenbsp;least good at, accounting for a large proportion of the drop in average lawyer scores compared to general US population scores.nbsp; A number of experiments verify that being unable to tap into one's own and others emotions can mean a significant delay, or total failure, to identify risks or dangers that the emotional part of the brainnbsp;is able to sense.nbsp; In a well-knownnbsp;card-playing experiment,nbsp;recounted in Malcolm Gladwell's book quot;Blink,quot;nbsp;participants are able to emotionally identify (measured by blood pressure and heart rate) the decks of cards that are stacked against themnbsp;many, many cards before they can rationally do so./p pOf course it is not just lawyers who can be out of touch with their emotional red flags, and it wasn't just lawyers that got us into this imbroglio.nbsp; Plenty of non-lawyer MBAs, PhDs and other regular types clearly missed the perception boat this time.nbsp; Nonetheless, one step toward better perception in the world of finance and public policy would be for the legions of lawyers involved--at the SEC and other government entities,nbsp;banks and financial institutions and law firms servicing them--to improve their connection with their and others' emotions, so that they can feel as well as think about the dangers out there, and hopefully avert just such a catastrophe as this one.nbsp; And the good news is that perception in this area of expertise can be improved./p pnbsp;/pimg src="http://feeds.lexblog.com/~r/LawPeople/~4/492518723" height="1" width="1"/

Full post as published by Law People on December 22, 2008 (boomark / email).