Sunday, December 11, 2011

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

Here is the first part of a paper of mine that is available on the Social Science Research Network. Although the paper is several years old and I do not necessarily still agree with everything I had to say back then, I still stand by by the criticism of neo-classical economics and firmly believe that the manner in which economics is practiced at present makes it at best irrelevant and at worst dangerous and destructive. I do not still think that behavioral economics--that is, adding more "realistic" behavioral assumptions to the neo-classical model in order to allow for irrationality and to explain irrational outcomes-- is the way forward, or even a good program to adopt, adapt and work with. Some of these points can be found in my post on ecological rationality here. But, as I said, the criticism is still valid and therefore I am posting an excerpt from the paper here for anyone interested to peruse.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty
by Doru Lung

The global financial crisis that began in 2007 was not predicted by standard economic theory which assumes rational actors, efficient markets and equilibrium. Alternative explanations of economic behavior that are based on psychological regularities which are observed in human behavior were until recently relegated to the fringes of the discourse regarding economic phenomena. It will be argued that this has proven to have been a mistake. Psychology has a long history in economic thought, but its influence on economic theory has ebbed and flowed over the years. Keynes had important psychological insights, but they have not been focused upon sufficiently in the last decades. Since the late 1970´s, though, new theories have emerged that are behavioral in nature. That is, they attempt to explain economic phenomena by being based on empirically observed psychological regularities of human behavior. This paper will show that psychology needs to be taken into consideration when reasoning about economic phenomena. The assumption of rationality that is prevalent in much of economic theory is based on a series of axioms and assumptions that are unrealistic. It will be argued that when reasoning about economic phenomena, that theory should be adopted which has more empirical support. The findings are that adopting a behavioral perspective of decision making has more explanatory and predictive power.   

Keywords: economics, behavioral economics, behavioral finance, behavioral corporate finance, rationality, efficient markets, psychology

Word count: 6675

A slightly different version of this paper formed part of the literature review of my dissertation for the Master of Business Administration degree of the University of Wales, but it has never been published before.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty
by Doru Lung

However unwillingly a person who has a strong opinion may admit the possibility that his opinion may be false, he ought to be moved by the consideration that however true it may be, if it is not fully, frequently, and fearlessly discussed, it will be held as a dead dogma, not a living truth” John Stuart Mill (Mill 1859 / 2008, p45).

On July 26, 2009 the on-line edition of the Guardian newspaper reported on the response given to the Queen of England by economists after she had asked why no one had seen the credit crisis coming. As reported by the Guardian´s economics editor Heather Stewart, the answer cited “a failure of the collective imagination of many bright people...[a] psychology of denial...[and] wishful thinking combined with hubris.” Nevertheless, Professor Tim Besley of The London School of Economics, one of the signatories of the explanation addressed to the Queen, “denied that economics as a profession had been discredited by the scale of the crisis, but admitted that unconventional ideas - about how herd psychology and bouts of irrationality can grip financial markets, for example - had sometimes received "less play" during the boom years” (Stewart 2009, p1). Less august audiences than the Queen may ask themselves whether it would not perhaps be fruitful to have a look at some of these “unconventional ideas” in order to see whether they have more explanatory and predictive power than the conventional ones.

The global financial crisis that began in 2007 has drawn attention to the academic theories which underpinned most, if not all, regulation and risk management, as well as the assumptions of many financial market actors.  Many observers have asked themselves just how the economist community as a whole seemed to be taken utterly by surprise by the events that eventually unfolded. Some critics, such as Stiglitz (2010) or Akerlof (2010), place partial blame on the efficient markets hypothesis (EMH) and its postulate of  rational behavior on the part of investors. The EMH is accused of not being an accurate description of the behavior of financial markets and for having played a major part in the complacent behavior leading up to the ensuing economic meltdown. The efficient markets hypothesis states “that financial prices efficiently incorporate all public information and that prices can be regarded as optimal estimates of the true investment value at all times. The efficient market hypothesis in turn is based on more primitive notions that people behave rationally, or accurately maximize expected utility, and are able to process all available information” (Shiller 1998, p1). Assuming that people rationally pursue their perceived self-interest and that on average the prevailing market result (price) correctly represents the best estimate of fundamental value given all available information is a powerful theoretical statement which, if accepted unquestioningly, can be used to explain away any mis-allocation of resources, excessive valuation, boom or bust. Unfortunately, trusting "the market" has led to some rather suboptimal outcomes: a quick perusal of any major newspaper will show that the ongoing turmoil in financial markets, the demise of some storied institutions and the bailout of others, the deepest recession since the 1930´s, sovereign debt crises, and millions of jobs lost are just some of the consequences of the boom and bust sequence whose effects are still being felt. "The market" is at any time the sum of the decisions of individuals in the face of risk or uncertainty. Studying how individuals really make decisions, therefore, can provide a better understanding of the functioning of markets and the behavior of investors. In what follows a critical look will be taken at the postulate of rationality in standard economic theory and the efficient markets hypothesis, and evidence of deviations from rationality as posited by standard economic theory from the fields of Behavioral Economics and Behavioral Finance will be presented.   

Not only has the efficient markets hypothesis come under fire, but the standard neo-classical economic model (SEM) has also been accused of having failed for both descriptive as well as normative purposes. Smith (2010), for example, sees academic economics as having given intellectual respectability to the deregulatory movement that led to the subprime crisis, ensuing credit crunch, recession and overall economic turmoil. That standard economic theory is not a good description of reality has not stopped massive amounts of theorizing from being done on the basis of rather unrealistic assumptions. In his The Methodology of Positive Economics Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This instrumentalist approach, however, is on precarious footing because when reality fails to conform to the model, it is not reality that is wrong. Rabin (2000) counters Friedman´s view by stating that "[c]eteris paribus, the more realistic our assumptions about economic actors, the better our economics. Hence, economists should aspire to making our assumptions about humans as psychologically realistic as possible" (Rabin 2000, p3). Rabin (2000) goes on to say that there is no reason that tackling economic questions should require an economic agent with 100% rationality, 100% self interest, 100% self-control, and many other assumptions that are used in economics but are not supported by the empirical behavioral evidence. Wilkinson (2008) sets forth the view that precision and psychological plausibility should be added as criteria for economic theory in addition to the criteria of congruence with reality, generality, tractability and parsimony. He goes on to show that adding realistic behavioral assumptions to economic theory does indeed fulfill all of the criteria mentioned above, and that the results are supported by empirical evidence. And Hausman reminds us that it is necessary to "look under the hood," that is, to evaluate the assumptions on which theory is based, especially “when extending the theory to new circumstances or revising it in the face of predictive failure” (Hausman 2008, p.185).

Are economic agents truly rational in the sense postulated by economic theory? This is a fundamental question whose answer has serious implications for academics, policy makers and, of course, market participants. The efficient markets hypothesis breaks down when market agents fuel bubbles that to everyone´s consternation eventually burst. Shiller (2002; 2006) shows us that markets are too volatile when compared to any discounted dividend model, and they can deviate from any measure of fundamental value, being prone to bubbles and busts. The huge swings in asset prices in both directions are just one indication that markets are not always efficient and that participants' behavior in the market does not conform to definitions of rationality.  Bromiley (2005) points out that if markets indeed tended toward equilibrium and were efficient and populated by rational agents, then there would be nothing to study since the optimal strategic decision would have already been made. A significant amount of empirical evidence has resuscitated the theory that (to use Keynes's [1936] felicitous phrase) animal spirits play a part in the determination of asset prices (see e.g. Akerlof and Shiller 2009) and has given birth to alternative theories that are behavioral in nature.

For the rest of the paper please go to the Social Science Research Network and download it.

Friday, December 2, 2011

Financial weapons of mass destruction strike again: naked

On October 23, 2008, in the middle of the biggest financial crisis since the Great Depression, Reuters ran an article entitled: “Greenspan says was ‘partially’ wrong on CDS regulation.”

“Former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong in his belief that some trading instruments, specifically credit default swaps, did not need regulation.
Henry Waxman, the Democrat who chairs the U.S. House of Representatives Committee on Oversight and Government Reform, cited a series of public statements by Greenspan saying the market could handle regulation of derivatives without government intervention.
"My question is simple: Were you wrong?" Waxman said.
Greenspan said he was "partially" wrong in the case of credit default swaps, complex trading instruments meant to act as insurance for bond buyers against default.
"I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders and the equity," Greenspan said.
When asked by Waxman if his ideology pushed him to make bad decisions, Greenspan said he found a "flaw" in his governing ideology that has led him to reexamine his thinking” (Dixon 2008).

CDS is an acronym for Credit Default Swap, a credit derivative that resembles insurance in that the buyer pays a premium to the seller in order to protect against the default of another entity. The purchaser of a CDS may have an insurable interest in the entity on which CDS’s are being written, by being a creditor or a bondholder, for example, which consequently means that a legitimate interest in protection against default exists, and the purchase of CDS’s can be seen as constituting a hedge, or a way of managing risk. In case the purchaser does not have an insurable interest, however, the purchase of a CDS is termed “naked” and constitutes nothing more than speculation that the entity on which the CDS is written will default. In case of default or a credit event the seller of the CDS has to pay the CDS holder the previously agreed upon sum, as stipulated in the contract. So while this may seem to be a fairly straight-forward insurance-type product, the fact that these instruments are traded OTC, or “over the counter,” however, means that no one really knows who has written how many CDS’s, on whom, for how much, to whom they have been sold, or whether there is any money to pay out in case of a default. This last point came into focus quite clearly when American International Group (AIG) had to be bailed out by the US taxpayer to the tune of over $180 billion in large part because they did not have any money to pay out on the Credit Default Swaps they had written (Sjostrom Jr. 2008).  

As reported by the BBC, back in 2003, when the notional amount of the entire derivatives market was only $85 trillion, Warren Buffet famously likened them to time bombs and “financial weapons of mass destruction,” some of which seemed to have been devised by “madmen,” and the whole derivatives industry was similar to “hell... easy to enter and almost impossible to exit” (BBC 2003). While Buffet did not specify CDS’s at the time, by September 2011, when, as reported by The Bank of International Settlements (BIS 2011), the entire derivatives market had swollen to over $700 trillion and the notional amount of Credit Default Swaps outstanding was still $32 trillion, down from $62 trillion in 2007, the Financial Times had no problem running an article titled:”CDS: modern day weapons of mass destruction.” The article by Chapman (2011) cited a paper by Calice, Chen and Williams (2011) which found that “for several countries including Greece, Portugal and Ireland the liquidity of the sovereign CDS market has a substantial infuence on sovereign debt spreads,” meaning that CDS’s could contribute to rising bond yields and thus push up borrowing costs and increase the risk of default by sovereign countries. Faced with contagion in the Eurozone and a possible cascade of defaults, the German government, on whose shoulders much of the cost of bailing out the periphery falls, demanded a ban on “naked short selling” and, especially, “naked” CDS’s as well (Baker and Peel 2011).

In an article calling for a ban on “naked” CDS’s Wolfgang Münchau (2010) noted that a “naked a purely speculative gamble [without even] one social or economic benefit [which is something that] even hardened speculators agree on. [Moreover a] universally accepted aspect of insurance regulation is that you can only insure what you actually own [and not] even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss,” especially if you proceeded to light a match to the house or push the boss of a cliff, which, after keeping in mind the findings from above, is what the whole thing amounts to. Greece, Portugal, Ireland, Spain, Italy are all facing ruinous borrowing costs in late 2011 and it is utterly uncertain whether the Eurozone will make it through 2012.

Credit Default Swaps are consequently living up to the moniker given derivatives by Warren Buffett: “financial weapons of mass destruction.” Alan Greenspan, Robert Rubin and Larry Summers refused to consider regulation of CDS’s back in 1997 when Brooksley Born testified before Congress that trading in unregulated derivatives would "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it" (van den Heuvel 2008). They refused, due to the belief noted above that the self-interest of rational economic agents and organizations would be sufficient to prevent the taking on of too much risk and “was such that they were best capable of protecting their own shareholders and the equity.” After admitting that this belief was wrong and that he had found a flaw in his worldview, his ideology, the disciple of Ayn Rand also admitted that: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year” (Andrews 2008). We are still dealing with the fallout and should prepare for worse, as reported by zerohedge, who address the meaning and significance of the derivatives market number reported by the BIS being

the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives...Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments...

for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price. 

What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year. 

There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year. It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.
But no matter what: the important thing to remember is that "they are all hedged" - or so they say, a claim we made a completely mockery of a few weeks back. So ex-sarcasm, the now parabolic increase in derivatives means that when the bilateral netting chain is once again broken, and it will be (because AIG was not a one off event), there will simply be trillions more in derivatives that no longer generate a booked cash flow stream for the remaining counterparty, until at the very end, the whole inverted credit0money pyramid collapses in on itself. 

Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over. 

Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.
And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over.


Saturday, November 19, 2011

To protect and serve the 1% and kick the crap out of everybody else

“If you want a vision of the future, imagine a boot stomping on a human face -- forever.” George Orwell, 1984

So disillusionment with the powers that be, anger and outrage at bailouts for banks and austerity for everyone else, disappointment with the lack of economic opportunity and excessive debt that can consequently never be paid back, are among the reasons that have led to the formation of the  #OWS (Occupy Wall Street) movement. After two months of peaceful protest and civil disobedience, the protesters have been attacked by the police in a concerted action across the country. Now, the police are obviously here to protect and serve the top one percent of the population that has most of the income and to kick the shit out of anybody else who dares to dissent or protest. Hyperbole, you say? Looking at the following pictures will make even the most law-abiding citizen cringe with disgust, disillusionment and despair. These emotions should quickly give way to outrage, anger and the determination to DO SOMETHING, anything, to fight not only against this level of crass brutality that is not to be accepted or tolerated, but against the corrupt, destructive finance driven junta that seems to have taken over the countries of the West, in what Simon Johnson called the quiet coup.

Friday, August 19, 2011

Towards Ecological Rationality

Economics as a discipline has detached itself from both psychology and political philosophy in an unfortunate turn of events that has led what used to be known as political economy to become an exercise in obfuscation through mathematics. By assuming what was supposed to be proven, and by blurring the lines between descriptive and normative theory, economics as it is currently practiced has become increasingly irrelevant to the description of the interaction of people going about their business. By forgetting that the economy is in the end comprised of people and instead hypothesizing a rational representative agent economics has assumed away that which it is supposed to describe and explain.

The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .

When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.

That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.

The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.

The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.

Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative.  It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured.  Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.

Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.    

Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.


Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: [accessed May 28, 2010]

Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: [accessed May 28, 2010]

Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed.  (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press

Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at: [accessed May 28, 2010]

Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan

Monday, July 18, 2011

Cognitive Biases Used in Propaganda Framing Deficit Debate and Wall Street Handout

Everyone likes to think that they are smarter than the average person. After all, how many of us would be ready to admit that they were in some way, shape or form inferior. Even those friends of ours from high school, and most of us who did not attend private boarding schools know these people, who accorded themselves “street smarts” while telling others that they were merely “book smart,” claim to be better at some things than the average. We all want to feel that we are good at something and even if this is not necessarily the case, we hold on to the illusion that we are somehow more skilled than the average Joe or Jane. Let us call this concept overconfidence.

In the academic literature it is called the overconfidence bias. Cognitive and behavioral psychology as well as behavioral finance and behavioral economics study the concept at length and in depth. Classic examples include asking everyone in a class to rate their driving ability as average, below average or above average. In study after study between 80 and 90 percent of respondents rate their driving ability as above average, which cannot be the case, since only slightly less than half can be above average. Other studies have repeatedly shown that when asked to rate our confidence interval in our statements, we are much more likely to state a much higher confidence level than our accuracy. Most of us like to think that we are smarter than the average, and do not wish to accept that, truthfully, we are probably by definition just about average in many of those attributes that are indeed normally distributed. Some of us might be better at some things than others, obviously, but we are not as superior as we would like to think. Nonetheless, this feeling of being superior, this confidence in our abilities, this sense that we will do better than most everyone else can lead us to take risks we normally would eschew, were it not for the nagging near-certainty that we are better, smarter and more insightful than the others, and that this time, for us, contrary to all evidence and history, things truly will be different, be it in business, investment, games or any other of the myriad activities we engage in where we are in it to win it. Think of housing and stock market bubbles, when real estate speculators and traders or money managers no doubt thought that they would be able to time the market and get rich quickly because of their superior skills and knowledge.  

Standardized testing reinforces this bias by inflating the egos of those whose scores are in the upper percentiles. These are the people who get accepted to the best universities, who go on to graduate school because they had GMAT or GRE tutoring classes, and some of these people think that they are the true producers and “value creators” of society, deserving six or seven or eight figure remuneration because of their superior natural or god-given abilities. Everyone else who is not as successful is either morally deficient or intellectually limited and their plight or poverty is therefore deserved and just.

The fundamental attribution error states that the successes of one’s group, class, clan, or tribe, generally called the in-group, are due to internal factors, such as talents, morality, hard work and intelligence, while failures are due to external, uncontrollable causes; with the mirror image being perceived as the reasons for the failures of the out-group, the others: inferior intelligence, lack of talents, or simply laziness, and with the out-group’s successes being consequently simply a matter of luck and often undeserved. So the fundamental attribution error is to attribute success to internal and failure to external factors for oneself or one’s in-group, and the opposite for those in the out-group.

Nowhere is this phenomena more prevalent and on display than in the United States of America, where the current culture war is further being waged on behalf of the top 1%, or was it 0.1%, or 0.01%, who not only receive most of the income but also own most of the wealth in the country. The current battle about “unsustainable” government spending, government needing to live within its means, and ever-present deficit reduction hysteria, is nothing more than an ideological battle being waged by those with means who believe that they should not have to pay any money for those without means, whom they consider shiftless bums and welfare queens who refuse to work and expect “handouts” from the government. Whatever the percentage of poor who do abuse the system, however large, small or inconsequential it might actually be, this discussion is not about them, it is only being framed in this manner. Framing effects arise when different responses are elicited based on whether the information is presented in a positive or a negative frame. Is the man or woman in dire straits because they were laid off due to downsizing, outsourcing, or company or business failure; or is the person unemployed because they are lazy and want free money from the government. By framing the narrative to portray the less well-off, the unemployed, and the poor in general in the latter manner, stereotypes are being created and reinforced. This is a further cognitive bias at work, the representativeness heuristic, which asks to what extent does A represent B, so to what extend do the poor and unemployed represent my stereotypical image of them. The representativeness bias is thought to be an innate and omnipresent trait, presumably brought about as a function of evolution. The manner in which it is being abused, though, is that through propaganda -- there is no other way to put it -- the unemployed are portrayed as lazy, shiftless, and not wanting to work, but expecting handouts and being able to sit at home drinking or drugging on the taxpayer’s dime. If you work and pay taxes, you are being led to believe that your money is not being spent on military armaments so that the US military can continue blowing up brown people somewhere to make the area safe for liberal capitalism and Halliburton and Bechtel; or that your money is going to bail-out Wall Street; rather, the public is told that taxpayers’ money is going to pay for the immoral and lazy who do not want to work. It is forgotten that the financial system brought about a collapse of the economy bringing along the unemployment that comes with recession and depression. But by reiterating this narrative that the poor and unproductive are unjustly taking money from the rich and productive, powerful interests serving right wing wealth -- see Rupert Murdoch and Roger Ailes along with the Koch brothers, for example -- are framing the discussion to serve their interests, which are to roll back any and all social programs since the New Deal and the Great Society, to take us back to a time when capital was king and the government did not dare tax the hard earned millions or billions of robber barons, when workers knew their place, and corporations would be unhindered in their pursuit of the bottom line, the environment, and the public be damned. Some might say we are already there.

Besides always having been a right wing ideological dream, one could call it Milton Friedman’s “wet dream”, to demolish the social welfare state, to “drown it in a bathtub” as per Grover Norquist`s wishes, currently the unemployed, unions public or private, those on welfare, and all those whose lifetime of work and paying into a system of social security in the expectation of receiving benefits when they retire have seen any government program suddenly become “unsustainable entitlements.” In unison the scream is: “We must cut all social programs or we will go bankrupt,” some louder than others, but all of them singing the same song: the Tea Party, the Republicans, some Democrats, and the President himself, at first unbelievably and unfortunately, but currently obviously and to be expected now that it has become perfectly clear that Obama stands to the right of most civilized conservatives on many issues.

The most insidious lie, however, is not only that the US is going broke because of social welfare programs, but that the US government can go bankrupt at all, after the surreal demonstration of money creation to hand over to an insolvent financial system and their investors and creditors. If one looks at the fact that a sovereign government which is in charge of its own currency can never go bankrupt, something that has long been explained and propounded by Professor L. Randall Wray, Marshall Auerback, Professor Bill Mitchell, Warren Mosler, and many others who understand modern monetary theory; and stunningly admitted by none other than “Helicopter Ben” Bernanke himself, who did indeed drop staggering amounts of money into the laps of the financial sector; and if one finds out from the report of the Special Inspector General of the Troubled Asset Relief Program (SIGTARP report here) presented to Congress by Neil Barofsky, who was in charge of SIGTARP, that up to $23.7 TRILLION were created in guarantees, equity injections, and toxic asset purchases, along with an extensive alphabet soup of programs ostensibly created to bring the US economy back from the brink of Depression and financial Armageddon, then any talk of budget constraint and the US running out of money is ridiculous and disingenuous.

The TARP; regulatory forbearance, which simply means that we will forget a while about bankruptcy rules which state that when you go bankrupt you are out of business, management gets fired and your assets get liquidated to pay your creditors; along with changes in mark-to-market accounting rules which allowed many to get obscenely rich during the bubble years but are now allowing insolvent institutions to hold worthless assets on their balance sheet at inflated prices, further kicking the can down the road in an exercise of extend and pretend; and letting the banking system finance itself at interest rates at 0.25%, money which is then promptly lent back to the government at several percentage points higher, might just strike informed observers as being simply gifts not only to the executives of too-big-to-fail banks for doing such a fantastic job of running their companies into the ground and helping the US economy come to the verge of Depression, but also a bailout of these companies’ bondholders and shareholders, since risk in finance was just a joke, and does not really exist due to the “Bernanke and Uncle Sam put”. “Profits are privatized and losses are socialized,” and everyone should read Yves Smith for her unmatched analysis of the events of the past years.

Once one realizes that for the US government money can simply be created and does not need to be borrowed, and that of the trillions that were created much was simply given away to the US banking and finance sectors and their bondholders, shareholders and creditors, which incidentally also bailed out a lot of foreign banks, then one might realize two things: that free market capitalism no longer exists, if it ever did anyway, when the government selectively chooses whom to rescue and how much money to give away, and that it is not the unemployed, sick and poor who have brought the country to the brink of ruin, but rather an extractive and predatory financial system that has co-opted the government to cater to its needs and not to those of the people. There is a reason it is called “Government Sachs”.

Because people are easily manipulated and susceptible to cognitive and behavioral biases, and because they have a short attention span and are more concerned with celebrity gossip than their own lives, not realizing that they are giving away their life energy to illusions created to keep them docile and distracted, highway robberies and sleight-of-hand such as TARP et. al. can brazenly be pulled and the biggest robbery in history does not concern citizens whose governments now have any protesters beaten bloody by riot police with batons and teargas. It is “bread and circuses” as it has been for most of human history. But when either the “bread” or the “circus” are missing, then people are forced to think about their own existence and maybe, just maybe, see through the corporatist fascist propaganda and wake up enough to become informed, indignant, independent and irrepressible.  

Wikinvest Wire