An overconfident ECB is sure to drop the ball

One of the features of the recession/depression is that there has been more focus on the role of economists and economics. Seen from the inside, what is stark is how lopsided this has been and how it throws up questions on policy formation.

Much of the economic talk has, perhaps perforce, been dominated by discussions on macroeconomic and macrofinancial issues, with real estate economics coming close on their heels.

Economics is first and foremost about the relative cost and benefit of choices. Different actors make different sets of choices; firms about employment and production, workers about work and leisure, consumers about goods and services, and so on. People make decisions based on a combination of rational and other reasons.

In the last 10 years or so, behavioural aspects have begun to enter into the core of (most) economic models. In part this “respectability” reflects and is reflected in the awarding of the 2003 Nobel Memorial Prize in Economics to Daniel Kahneman and Amos Tversky.

Again it may seem strange but for much of the last 50 years the rational calculation of trade-offs was the only way to model much of economics, only in the sense of being accepted by the academy.

The last decade has seen this challenged. Models and policy now, with the glaring exception of “high macro”, are comfortable with the notion that people matter in terms of how they decide their choices and that these choices are not always a cold rational decision.

What is rather startling, however, is how relatively little these behavioural approaches are evident in the media debate, which perhaps reflects the relative paucity of related researchers in this area in Ireland.

Few economists or finance researchers take a behavioural approach. So what can behavioural approaches tell us about recent events?

One of the main planks of this approach is that of loss aversion, arising from the Kahneman and Tverskey refined Prospect theory. This in essence says that we feel the pain of a given loss far more than we feel the gain of the same amount won.

Consider the imposition of the household and house taxes. The amounts are small but the pain large.

A further major plank is ‘hyperbolic discounting’. Recall the recent discussion of the “win” in the restructuring of the promissory notes; much of the putative gain emerges from delaying any repayments, in the knowledge that from today’s perspective, €1bn in 20 years is seen as much less than €1bn.

Beyond this we find, in behavioural economics, that we need to understand the biases and shortcuts (heuristics in the jargon) that people take when faced with decisions under (especially monetary-related) choices. For example we tend, as people, to anchor prices and wages and other monetary amounts to recent levels regardless of what “fundamentals” tell us.

We tend to disregard evidence from the past over evidence from more recent times, and we engage in what is called “base rate neglect”, wherein we effectively assign events to representative categories.

Thus we find statements such as “this time is different”, based on the last five years and the fact that full information about the past 50 years is not being used. There is a danger that we assume for example that there will be a neverending recession — there won’t be. This too shall pass, and we will eventually have another credit or related bubble and shall make similar mistakes.

Finally consider overconfidence. It is more prevalent in men than in women, and success breeds not just confidence but overconfidence.

Then look at the ECB — hard though it may seem to us here they have had success, in that they have kept the euro together, dampened the fires of speculation, reduced bond yields and kept inflation low.

The male-dominated ECB must be feeling confident, and the longer the run of success goes on, the more overconfidence will be bred. Overconfidence breeds failure.

We must therefore be prepared for the inevitable crisis that will happen when the overconfident ECB, sometime in the next decade, drops the ball. With our luck that will happen just as the next bubble pops. But then we are human after all.

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