Decision Making or Irrational Perseverance applied to the Euro Issue

By Roger Claessens, prof UBI, Brussels on

This first part of the text is based on: “Thinking fast and slow” by Daniel Kahneman[1].

It is by a happy coincidence that a friend mentioned I should be reading the book of Nobel Prize winning economist, Daniel Kahneman on “Decision Making”. My only regret is that this book was not published years ago and that I did not benefit earlier from the remarkable observations of the author, reason why I want to share this with you and the students who follow my courses.

“This book is a tour de force by an intellectual giant; it is readable, wise and deep. Buy it fast. Read it slowly and repeatedly. It will change the way you think, on the job, about the world, and in your own life.” (Richard Thaler, professor of behavioural science and economics, University of Chicago)

The concept

The DECISION MAKING PROCESS is based on two systems, the first

one is the intuition and the second one is the analytical part of the decision making process.

SYSTEM 1 operates automatically and quickly with little or no effort and no sense of voluntary control. It includes the innate skills we share with other animals.

SYSTEM 2 allocates attention to the effortful mental activities that demand it, including complex computations. It requires attention and effort. System 1 does the fast thinking & the effortful and slower system 2 – which does the slow thinking – monitors system 1 and maintains control as best as it can within its limited resources. However, system 2 is not a paragon of rationality. Its ability is limited and so is the knowledge to which it has access. When system 1 runs into difficulty it calls on system 2 to support more detailed and specific processing.

Based on above, we underline a few considerations by the author. It is natural for system 1 to generate overconfident judgements because confidence is determined by the coherence of the best story you can tell from the evidence at hand. Therefore your intuitions will deliver predictions that are too extreme and you will be inclined to put far too much faith in them.

When people believe a conclusion is true, they are also very likely to believe the arguments that appear to

support it, even when these arguments are unsound. The extend of deliberate checking and search is a characteristic of system 2 as system 1 provides impressions that often turn into believes and is the source of impulses that often become your actions. Good decisions often fail by lack of motivation and…high intelligence does not make people immune to biases! The sense making machinery of System 1 makes us see the world as more tidy, simple, predictable, and coherent that it really is. The illusion that one has understood the past feeds the further illusion that one can predict and control the future. These illusions are comforting. They reduce the anxiety! The author underlines various illusions such as skills, educated guesses, the ignorance of one’s own ignorance, forecasting ability…

Note that EXPERTISE depends essentially on the quality and speed of feedback, as well as on sufficient opportunity to practice. Evaluating expertise means considering whether there was an adequate opportunity to learn even in a regular environment. Intuition is nothing more and nothing less than recognition. We are often wrong, and an objective observer is more likely to detect our errors than we are. Luck plays a large role in every story of success! Besides, when faced with a difficult question, we often answer an easier one instead, usually without noticing the substitution. There are several ways human choices deviate from the rules of rationality. We focus on what we know and neglect what we do not know, which makes us overly confident in our beliefs.

Both in explaining the past and prediction the future, we focus on the causal role and skill and neglect the role of luck. We are therefore prone to an illusion of control. This underlines the concept that a reliable way to make people believe in falsehoods is frequent repetition because familiarity is not easily distinguished from truth. Authoritarian and marketers have always known that fact! Very little repetition is needed for a new experience to feel normal.

In addition to above mentioned considerations related to decision making, we tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence. Optimism is a state of mind, often inherited! More often optimism leads to underestimate the odds they face and do not invest sufficient effort to find out what the odds are. “The evidence suggests that optimism is widespread, stubborn and costly!” Whenever you form an evaluation of complex object, you assign weights to its characteristics. The weighting occurs whether or not you are aware of it; it is an operation of system 1. The weights are certainly correlated with the probabilities of the outcomes. The more probable an outcome, the more weight it should have

Applying the concept to the economic situation

Let us see how we can use these observations to the economic environment of most European Countries and more specifically to the Euro-Zone.

Before doing so let us first structure our thinking along the lines of another Novel Prize winning economist, Paul Samuelson[2], thanks to whom I learned quite something about economics. He represented the economic circuit with four circles. I took the liberty to add two! One circle represents you and me, the consumers whose needs and wants are met by the producers. We meet each other in the markets, like the supermarkets and as we need money we meet each other in the employment market.

Money, generally referred to as money supply, makes it possible.

Every economy has to address three major questions:

1. ” What to produce”, often dependent upon the purchasing power of the consumers,
2. “How to produce”, dependent upon competition and
3. “For whom” dependent upon political choices.

The guardian of the system as far as money is concerned is the central bank, in the Euro-zone de ECB, independent from the Government. The central bank has a variety of tools at its disposal to balance the goods and services on the market and the money to purchase it. Indeed, it can change short term interest rates, print more money, purchase bonds, recommend different ratios to the commercial banks and last but not least, it can increase or decrease the fractional reserve requirements.

Please note that any change occurring in one of the six circles automatically impacts on one, if not more, of the other circles. For instance, when the central bank lowers the interest rates it impacts, or hopes to impact consumers and producers, by allowing them to borrow cheaply. In turn this would mean, more demand for labour and ultimately an

increased

GDP and consequently an increase in Government income.

The key question central bankers must answer is: “What is the correct money supply level?” The easy answer is enough to buy all the goods and services produced, so that full employment is reached without a rise in prices”. However, therefore we need to know how people tend to hold onto their money before spending it. In this context we have to look at another factor, which is the velocity of money. This boils down to holding an approximate balance between the two sides of below equation[3].

PQ = M.V

• P = price level of goods and services
• Q = quantity of goods and services produced in a national economy
• M = the monetary mass (the assets of the consumers and the entrepreneurs, with corresponding liabilities for the banking system and the central bank)
• V = velocity or speed of circulation of the monetary mass

If velocity is stable and if the central bank can control the money supply the authorities have a powerful tool with which to speed or slow down the economy. The money supply directly controls the engine. If velocity is unstable, however, if people vacillate between holding a lot and holding little of their funds in currency and checking account, controlling the money supply is not very helpful!

However, another big influencing body of the system is the government with a large variety of laws, rules and regulations just think about fiscal laws to mention one set of laws.

System 1 – Intuition

Can we make decisions related to the Euro based on our intuition?

Clearly, the answer is no! To start with we do not have a stable environment. Besides, we have never been exposed to this environment. We all knew that the introduction of the single currency required not only a common monetary policy but equally a common budgetary policy. It is a unique situation in modern history to have a variety of countries sharing a single currency whilst pursuing different budgetary policies. You can conclude that the only way to look at the present economic situation is to have system 2 checking whatever system 1 might tell you. As mentioned earlier, system 2 requires know-ledge, structure, data….a lot of thinks most of us do not have, reason why often discussions turn into political debates rather than good judgements on future actions

System 2 – Analysis

From the very beginning of this modern adventure the requirements where quite clearly spelled out. Think about the comments of Milton Friedman[4] in numerous articles stating that failure would be inherent to this currency without common budgetary policy. The central point for statistical analysis is the central bank in most of the member states, besides the governmental statistical agencies. There is not much to discover there. However, beyond data there are man and woman. For instance, culture, work and leisure habits, corruption are not reflected in figures but ultimately in productivity, competitiveness and economic success.

If system 2 in this case is certainly to be preferred to system 1, it is in the final analysis a matter of difference in culture that shapes different policies. Without forcing some issues, cultures will not grow towards each other, on the contrary.

Conclusion

In fine, overestimation of intuition and underestimation of what we need for the analytical part of the decision making process will result in IRRATIONAL PERSEVERANCE!

This should not be the case for the Euro. Therefore, the path to choose is quite straightforward if we choose to keep and have the Euro as a major world currency. It is the path of a tighter integration of the budgetary policies of its members. The alternative, in my view, a disastrous one, would be to revert to the national currencies. It would certainly decrease our competitiveness versus the USA and China, not to mention the BRIC countries.

We need to take a long term view here. As an example, if you looked at the results of the 2012 Olympic Games and added the medals of the European athletes versus the USA or China, Europe would be by far the most successful bloc of nations. Extrapolate this thinking in the economic field and you will realise the significance of choosing a long term view, despite recent hic ups. Remember, economics is about the analysis of choice and its consequences! The important question is the third one in the circuit of Samuelson: “for whom?”

To finalise this article and provide some moments of reflexion, let me quote these lines from M. Daniel Kahneman: “An inability to be guided by a healthy fear of bad consequences is a disastrous flaw!” “When you specify a possible event in greater detail you can lower its probability.”

Finally, it is the author’s conviction, and I might add mine as well, that luck plays a major part in the success related to the decision making process as well as the fact that: “Our comforting conviction that the world makes sense rests on a secure foundation which is our almost unlimited ability to ignore our ignorance.”

So, let us hope for some luck on the Euro issue and good doses of modesty for the decision makers and a much needed long term view.