Jan 16 2009

Irrational choice theory

Category: economy,governmentharmonicminer @ 10:41 am

On rational choice theory, risk aversion in economic behavior, and what happens to risk aversion when the risks are someone else’s, not yours:  Irrational Economic Man by Michael Shermer

research in behavioral economics has revealed that many, if not most, of our economic choices are driven not by rational calculations but by deep and unconscious emotions that evolved over the eons. Among these irrational emotions is “risk aversion,” a psychological effect that is actually part of the reason that financial markets work so well. People are more averse to risk than traditional economics would dictate, and that restraint helps keep most speculative market behavior in check.

As everyone knows by now, many of our major financial institutions weren’t nearly averse enough to risk over the last decade and a half. In seeking quick and carefree profits, along with trying to appease politicians pushing for wider homeownership, they tossed all restraint out the window, with devastating economic consequences. How did this happen, and how can we keep it from happening again?

It’s all worth reading, but here’s the payoff, pretty obvious to anyone who’s been paying attention:

By entering the business of risk protection, the government has reconfigured the economic game: in profits, we’re capitalists; in losses, we’re socialists.

Let’s be brutally honest. The CEOs, CFOs, and COOs of the Wall Street financial giants who signed up for our new corporate welfare program are now welfare queens. They’re on the dole. In an ideal world, they would all be put on a very public welfare-to-work program—as in the welfare-reform movement of the 1990s—that tethered salaries directly to the amount of money paid back, with interest, to the people who earned the money in the first place: taxpayers. The corporate leaders could even appear on a new Fortune 500 list, ranked by how much of our money they had returned.

What would help ameliorate future financial crises? The government should not be in the business of hiding real risks through political imperatives, or of insulating corporations from the risks that they have freely taken. Doing so confounds the normal risk signals that keep the market in balance. For risk aversion to keep markets working, people and corporations have to be allowed to assess real risks and to fail if they take inappropriate risks. Only the people who produce wealth can properly assess how best to risk it in future investments. The Warren Buffetts of the world can do that. The Ben Bernankes cannot.

Yep. As I’ve written many times before, the laws of economics are as real as gravity, and as unforgiving, and cannot be repealed by government fiat. But just as you have a few glorious seconds of freedom with an incredible view after leaping off the top of the Grand Canyon, government interference in market mechanisms can produce a real rush… for a short time.

Unfortunately, I have the distinct impression that the economic policies of the administration of President-elect Obama are going to involve simply climbing a bit higher (maybe quite a bit higher)  before jumping (or being pushed)…  sort of like erecting the Space Needle next to the Grand Canyon, and then jumping off that.  It’ll be a glorious ride, with a really exhilarating dénouement.  Think of it as printing enough money to build a 40 story tower, lighting a match, and then jumping off as the flames rise.

I wish I could just stay home from this particular vacation, but I have the feeling we’re all in for a wild ride.

UPDATE:  Privatized Profit, Socialized Risk discussed here.

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