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Saturday, March 28, 2009

"It Pays to Understand the Mind-Set"

More on the usefulness of quantitative models:

It Pays to Understand the Mind-Set, by Robert J. Shiller, Economic View, NY Times: ...[A] “theory of mind” — defined by cognitive scientists as humans’ innate ability, evolved over millions of years, to judge others’ changing thinking, their understandings, their intentions, their pretenses ... is a judgment faculty, quite different from our quantitative faculties.

In October 1989, I attended a conference at the National Bureau of Economic Research ... on “The Risk of Economic Crisis.” The conference still sticks in my mind because of a paper delivered there by Lawrence H. Summers... I came away with a recognition that a severe contraction, even a depression, could indeed come again. (His and other papers from the conference are here.)

Mr. Summers told a fictional but vivid story of a big financial crisis ... He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high... Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. ... The popular view was that “with a reduced cyclical element, the future would be even brighter.”

Furthermore, he said, “lawyers and dentists explained to one another that investing without margin was a mistake, since using margin enabled one to double one’s return, and the risks were small given that one could always sell out if it looked like the market would decline.” ...

His fictional account went on to describe the early signs of the crisis, “...problems began to surface,” he said, adding that a “major Wall Street firm was forced to merge with another after a poorly supervised trader lost $500 million by failing to properly hedge a complex position in the newly developed foreign-mortgage-backed-securities market.” He went on to describe how this provocation led to a change in psychology and a market crash and problems in banks and credit markets.

His fiction concluded, “The result was the worst recession since the Depression.”

How did he write a story 20 years ago that sounds so much like what we are experiencing now? It seems that he was looking at factors of human psychology... Mr. Summers evidently knew that an event like our current crisis was waiting to happen, someday.

Ultimately, the record bubbles in the stock market after 1994 and the housing market after 2000 were ... driven by a view of the world born of complacency about crises, driven by views about the real source of economic wealth, the efficiency of markets and the importance of speculation in our lives. It was these mental processes that pushed the economy beyond its limits, and that had to be understood to see the reasons for the crisis.

Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

Still, in our current crisis, we need to try to understand the perils we face. The motivation for a vigorous economic recovery program must come, at least in part, from our forecasts of the dangers ahead. The greatest risk is that appropriate stimulus will be derailed by doubters who still do not appreciate the true condition of our economy.

Exactly how to implement this forecasting technique - one based upon a theory of the mind - is a bit vague.

    Posted by on Saturday, March 28, 2009 at 04:05 PM in Economics | Permalink  TrackBack (0)  Comments (17)

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