Daniel Kahneman on economic models:
Irrational everything, by Guy Rolnik, Haaretz: Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people's irrational behavior when it comes to making economic decisions. ... But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.
They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."
According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless. ...
"In the last half year, the models simply didn't work. So the question arises: Why do people use models? I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can't predict hurricanes. Do we use the system anyway, or throw it out? It turns out they'll use it."
Okay, so they use it. But why don't they buy hurricane insurance?
"The question is, how much will the hurricane insurance cost? Since you can't predict these events, you would have to take out insurance against many things. If they had listened to all the warnings and tried to prevent these things, the economy would look a lot different than it does now. So an interesting question arises: After this crisis, will we arrive at something like that? It's hard for me to believe."
The financial world's models are built on the assumption that investors are rational. You have shown that not only are they not rational, they even deviate from what is rational or statistical, in predictable, systematic ways. Can we say that whoever recognized and accepted these deviations could have seen this crisis coming?
"It was possible to foresee, and some people did. ... I have a colleague at Princeton who says there were exactly five people who foresaw this crisis, and this does not include ... Ben Bernanke. One of them is Prof. Robert Shiller, who also predicted the previous bubble. The problem is there were other economists who predicted this crisis, like Nouriel Roubini, but he also predicted some crises that never came to be."
He was one of those who predicted 10 crises out of three.
"Ten out of three is a pretty good record, relatively. But I conclude from the fact that only five people predicted the current crisis that it was impossible to predict it. In hindsight, it all seems obvious: Everyone seemed to be blind, only these five appeared to be smart. But there were a lot of smart people who looked at the situation and knew all the facts, and they did not predict the crisis." ...
The interesting psychological problem is why economists believe in their theory, but this is the problem with the theory, any theory. It leads to a certain blindness. It's difficult to see anything that deviates from it."
We only look for information that supports the theory and ignore the rest. "Correct..." ...
Let's end with your story of the Swiss soldiers and the map of the Pyrenees. I know why the map helped the soldiers: it gave them confidence. But why didn't they use a map of the Alps? Why don't we use the right economic models, ones that are relevant to extreme cases as well?
"Look, it's possible that there simply is no map of the Alps, that there is nothing that can predict hurricanes."