Posted by: Dirk | May 30, 2012

(Book review) Thinking, fast and slow

“Problems can never be solved by the way of thinking that caused them.”

Albert Einstein

Daniel Kahneman’s new book is a tour de force. He develops his ideas of a world in which people use two modes of thinking: one is fast and one slow. The fast method relies on intuition and is prone to biases. While Gerd Gigerenzer calls this heuristics and believes that it is not by default a bad way of decision-making, for Kahneman it is heuristics and biases that make humans chose in non-rational way, which is a bad thing.

Kahneman provides an excellent overview of his own and others research regarding decision making. There is a whole section on overconfidence and one on choices which deals with different statistical worlds. This work is inspired by Taleb’s “Black Swan” and completes the picture of humans trying to figure out probabilities and at times miserably failing. The interesting consequence is that we are led into the territory of philosophy. Should people be punished for making errors? Let me quote a paragraph from page 412 to give you an idea what this discussion is about.

In a nation of Econs, government should keep out of the way, allowing the Econs to act as they choose, so long as they do not harm others. If a motorcycle rider chooses to ride without a helmet, a libertarian will support his right to do so. Citizens know what they are doing, even when they choose not to save for old age, or when they expose themselves to addictive substances. There is sometimes a hard edge to this position: elderly people who did not save enough for retirement get little more sympathy than someone who complains about the bill after consuming a large meal at a restaurant. Much is therefore at stake in the debate between the Chicago school and behavioral economists, who reject the extreme form of the rational-agent model. Freedom is not a contested value; all the participants are in favor of it. But life is more complex for behavioral economists than for true believers in human rationality. No behavioral economist favors a state that will force its citizens to eat a balanced diet and to watch only television programs that are good for the soul. For behavioral economists, however, freedom has a cost, which is borne by individuals who make bad choices, and by a society that feels obligated to help them. The decision of whether or not to protect individuals therefore presents a dilemma for behavioral economists. The economists of the Chicago school do not face that problem, because rational agents do not make mistakes. For adherents of this school, freedom is free of charge.

This extensive quote shows very clearly that there are two competing world views. Both views of the world are then connected to one view of macroeconomics. The Chicago school is connected to profit-maximizing firms in a neo-classical world without uncertainty and problems of distribution (stocks of debt/wealth), while the behavioral view is connected to the heterodox view of the world were things can go wrong due to bad decisions of investors (which are not independent of bad decisions from policy-makers, businesses and households).

At this moment in time, we are in a Keynesian world where mistakes have been made. Investors have generated billions of dollars worth of non-performing loans, and now businesses are cleaning up their balance sheets. This is especially difficult for banks in Europe, where the financial sector was completely wrong when sovereign bond yields converged in the years leading to the crisis. Greek sovereign bonds should have been much cheaper, and German ones more expensive, as we and the market now understands. There are many more issues in which the so-called mainstream in economics was wrong, and new thinking is required to improve institutions that exist, and create new ones. This process will take some years.

One day, when today’s problems lie securely in the past, there will be a renewed period of (financial) stability. If Hyman Minsky is right, then this stability will lead to instability, and we will repeat the cycle once more. Nevertheless, it is worth reforming the institutions in order to create more stability and get rid of the wasteful and inefficient instability that we have today. After the Great Depression and WWII, the institutions that had been set up generated economic growth from roughly 1950-1971. Without an elaborated financial market providing possibilities for speculation, savers were forced to invest in the real economy. This is what the new system must achieve as well.

We need to concentrate power over financial resources with those who are psychologically fit to manage this power. Politicians who are up for election and therefore controlled by the public seem to me a better idea than psychologically unfit investors, like those described in a recent article in the Journal of Business Ethics. Since the abstract is not available online, here is an excerpt from the reporting of the Toronto Star:

A peer-reviewed theoretical paper titled “The Corporate Psychopaths Theory of the Global Financial Crisis” details how highly placed psychopaths in the banking sector may have nearly brought down the world economy through their own inherent inability to care about the consequences of their actions.

The author of this paper, Clive Boddy, previously of Nottingham Trent University, believes this theory would go a long way to explain how senior managers acted in ways that were disastrous for the institutions they worked for, the investors they represented and the global economy at large.

If true, this also means the astronomically expensive public bailouts will not solve the problem since many of the morally impaired individuals who caused this mess likely remain in positions of power. Worse, they may be the same people advising governments on how to resolve this crisis.

Which brings us back to the Chicago school of economics and rationality. What if there are irrational people and they rule huge parts of the world? What if they drive others into irrationality through fear, anger, etc.?



  1. Nice review, Dirk. I have just now started reading the book and from what I can tell, it is really quite excellent. What really bothers me in this whole debate is that models are taken as truths and then built upon unchecked and unreflected. We then limit our debate to the range of answers provided by these new models, because the old models with assumptions such as rational expectations are taken as truth.

    Let me try to illustrate this example. Say we apply the Chicago School approach was applied to street traffic and we assume everybody is free to choose, hence no rules. The system would probably be functional, be it with a fair amount of accidents. A set of patterns, call them market rules, emerge along with an incentive system. People would buy larger cars because they would be less likely to be killed and others would allow them to have the right of way out of fear of having an accident with them. Thus reckless behavior is punished severely only to the ones with small cars, because the big SUVs are too big to fail. We are aware of this behavior, in part thanks to the advances in behavioral economics, but until the crisis much the research was still dogmatically pursued without reflection.

    My point is that we have to be much more critical of assumptions and our believes we carry into the models. Yes, free markets are generally good. But only if we set up proper institutions and rules and have good information. Yes, we we need to model the economy in a certain way, but we need to be aware of the limitations these models really have.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


%d bloggers like this: