Irrational choices: humans error-prone in loss-related decisions in our design

A video presentation of a brilliant experiment conducted by Yale Psychology Professor Laurie Santos. Santos finds that our error-proneness, at least for decisions related to losses, appears to be part of our innate cognitive design — something wired in our cognitive machinery for reasons having to do with evolutionary survival as early as 35-million years.

In a nutshell, humans & their distant cousins think in terms of loss, loss aversion & relativity even in circumstances when thinking in those terms is to their detriment. The experiment creates a Capuchin money market, with money, trade and gambles!

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‘Schumpeter’, The Economist’s New Business Column

This news was worth breaking the posting-hiatus taken by the author of the blog to tend to work and dissertation-writting. It is highly symbolic that a publication that has a long-standing tradition of waving the banner of neo-liberal capitalism and regularly expounding on the virtues of a free market, would name its new business column ‘ Schumpeter.’  The namesake, Joseph A. Schumpeter, was deeply critical of free market capitalism in its purest form, favouring instead a brand of capitalism with a social dimension: social capitalism (also known as socialism). He saw an inherent flaw in the ‘bigger is better’ notion that carried the day in a market capitalist economy, and rather advocated for a ‘smaller is better’ model. That Schumpeter is the namesake of The Economist’s new business column suggests a profound shift of how its readership understands markets (economists, financial specialists, decisionmakers), summoning perhaps a new era of restructuring and reforming the old free market model. This is precisely what the newspaper seems to suggest.

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Bail-out extravaganza?

It is becoming a bit of a routine: every few weeks I will wake up to the news that some big firm, “too big to fail” needs to be bailed out (yet again). This week it was AIG. Billions of dollars are already being negotiated by Congress for the new emergency bailout before I even drink my morning coffee — and all just for the asking. AIG seems to be taking turns with Citigroup, GM, Fannie Mae & Freddie Mac.

Billions of dollars of taxpayers’ money going where exactly? To the companies of course, but how is it being used differently than the last time that gives the taxpayer any reassurance whatsoever that it will make a difference this time around? It is deeply unsettling how evasive the answer to this latter question has proven to be.

Lets be clear, I believe that a positive & long-run outlook of the economy is the best attitude to have, otherwise consumer confidence is doomed to be in the doldrums indefinitely (In fact, it can lead to a self-fulfilling prophecy of stagnation: if we do not believe the economy is doing well we will not spend & the economy will not be doing well). In order to keep this positive & long-run attitude, however, we need to have some assurance that spending is safe (in stocks, for example, but also in basic commodities).

It is not at all reassuring to witness the government spend so liberally on bailouts in order to stem the spiraling path of the economy, and at the end of the day, only be able to boost the Dow Jones & other market indexes on the day of the market-cash infusion announcement; then see those gains lost miserably two days on with the markets hitting a new low (this, of course, alongside the increase in deficit implied by the spending). There is too much volatility in the markets. That is having the long-run optimist worry. This is not good.

I trust the Obama Administration to be one that relies on careful & expert judgment. After all, a whole commission for economic recovery has been convened comprising of private sector, labor & academic figures. The convention of this commission is most laudable, yet I am starting to feel greatly uneasy about what appears to be the continued & unquestioned fulfillment of bailout requests for corporate entities.

In the first round of bailouts AIG, Citigroup & other financial sector firms requested federal funds to ease inter-bank lending. They worked out the numbers & came out with a handsome figure that would help them through the slump. Such government intervention is appropriate & was necessary the first time around, but why is it that we are having second and even third waves of bailout requests ? How come no one is asking why the initial cash is already out and how it could have been used more effectively?

Actually the latter question has been asked by a handful, and the answer has been that an important portion of the first bailout package was hugely important in stopping a freeze in inter-bank lending that would have otherwise brought the economy to a standstill. Yet, there is another important portion of it that appears to have been used much less wisely, and without much oversight or accountability. An apparent deadweight loss. And now these companies are asking for more?

Was the accounting done incorrectly the first time around? And why isn’t more restructuring demanded from these firms? How about liquidation of assets? (Fannie Mae has its most portentous headquarters on prime real estate property in northwest Washington D.C. The historic building cannot be inexpensive to maintain.) How about breaking up a company into separate corporate entities? How about structural reform in corporate business models? How about government intervention that demands step-by-step restructuring deadlines, with bailout fund disbursement contingent on achieving pre-established goals for each phase, with a finite & non-renegotiable bailout price-tag? AIG has been scarcely transparent in their corporate restructuring plans and yet it feels entitled to more…

And, for other industries, and namely the auto industry, I know it would be a heartbreak for the United States to see GM go — a very economically painful heartbreak. This heartbreak, however, is starting to appear far more appealing than the one induced by heavy spending to save a company that has done relatively little to restructure (in comparison, to say, Ford, who after the first bailout negotiations for the auto industry realized that its survival relied on being a smaller firm & is restructuring accordingly). It needs an ultimatum, and one that provides a survival choice that is spelled out as such & which includes specific immediate-, short- & medium-term restructuring goals in the context of a finite bailout budget. The other option for all of these companies has also to be an option:  namely, non-survival.

After the government allowed Lehman Brothers to fail and felt the aftermath of the financial sector unraveling, it is very hesitant to really consider this choice for other firms, fearing another spiral. Nevertheless, every time a company makes another request for funds, perhaps because “they are too big to fail” we sustain another blow in the markets & confidence all but freezes. This is in part because we are no longer sure that the government can really save them, but also because we have not really seen what is different about them since their first bail-out request & so their potential failure is one that implies, in the eyes of many, government inefficient spending (also known as waste).

I really hope that periodic restructuring audits for bailout recipients, as well as a more transparent flow chart of government allocations & conditions for lending (including bailout limits) are put in place. That may be very painful (as it may imply some failures) & take us crash-landing to the bottom, but it is not until we reach that bottom that we can build up. It is simply most important that we sustain confidnece in the governments’ recovery plan. The uncertainty of whether bailout money will work or not in the absence of any regulatory changes & conditions is doing exactly the opposite: extending the horizon of caution & withholding for consumer spending & thinning the ranks of long-term optimists. This is not good news for the economy.

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Caps on Executive Compensation

There are a few things for the libertarian side of many of us feeling queasy about the Administration’s caps on executive compensation to ease that queasiness & anxiety:

1. Executive compensation as currently structured rewards very high-risk tasking behaviour, even when the probability of failure of an investment is high (the high returns are an attractive incentive). The sub-prime mortgage crisis is a prime example.

2. Risk-taking itself is not a problem, because it is balanced out by the risk of failure, but government bailout money takes away completely or reduces greatly that failure risk for companies: “the government will bail us out because we are “too big to fail”! This creates a huge moral hazard problem.

3. Nevertheless, bailout out money is a necessity at this time given the current economic conditions (so that banks keep lending and business can keep operating and the U.S. economy does not spiral down to a more severe recession). So government intervention is important in helping the markets, but it needs to address irresponsible risk-taking (via restrictions on executive compensation to companies receiving bail-out money). The fact they are receiving bail-out money means they would have otherwise failed w/o government intervention, and would have sustained a loss much greater than that imposed by executive compensation restrictions (e.g., be fired, file bankruptcy, close all together)… these stipulations of executive compensation are not a cap on innovative thinking, rather they are a form of accountability and moderation of the moral hazard problem… it provides an incentive for companies to restructure and become profitable again to return to higher levels of compensation… this time with a little more care in their risk-taking decisions, since low performance may mean that either they will fail or if the government bails them out again, a slash in their salaries… That sound like a sound incentive structure to me.

4. No doubt mechanisms to fine-tune this cap to the financial profile of a company will be in place (e.g., overriding the half a million per annum cap by shareholder vote & share options)

5. Executive compensation caps exist elsewhere in the world (whether imposed by intervention or out of normative corporate standards). For example, in Japan, it is framed as an issue of equality (or rather, of not promoting extreme inequality). The ratio between the lowest and highest paid employer is 1:10 in Japan, whilst it is around 1:50+times in the United States. It works: Japan is still on the vanguard of innovation in high tech products (their economic problems are due to other factors, including the fact that the Japanese save too much and they do not spend enough — that is certainly a problem we do not have in the United States!).

No, the Obama Administration caps will not thwart growth or innovation. Yes, they will provide responsible corporate governance.

Indeed it is due time to clip those golden parachutes…

by Maria Reyero

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