December 31, 2012
Over the past few days, I have received all sorts of economic forecasts of 2013 penned by economists in large financial outfits who are confidently telling me what is going to happen next year. Most of these guys were the same people who didn’t foresee this crisis, yet few have lost their jobs and here they are, without the slightest hint of doubt, outlining what is likely to happen in 2013.
Of all the characters we should fear, the overconfident economic forecaster is surely one of them. When the Queen of England asked why none of these professionals warned of the credit crunch, she was only articulating what many people must have thought, which is “if you guys are so clever, why didn’t you see this crisis coming – and if you didn’t see it coming, why should I listen to you now”?
The failure of economics to predict human behaviour is a significant charge that modern economists have not properly answered and the failure to answer this accusation adequately has undermined economics as a whole.
In the final column of the year, we are going to take a quick look at the state of the economics game and ask whether the fundamental laws of traditional economics bear any relation to reality or offer any insight into how people actually behave every day.
Maybe the first place to start in analyzing the failure of economics is to start at the first assumption of modern economics: that people are rational.
Economics, as taught in our schools and universities, begins with the assumption that we are rational. Nothing could be further from the truth. Humans are possibly the most irrational of animals. We are driven by emotions, exuberances, impulses and frenzies. We fall in love, gamble and even support useless football teams.
These irrational, illogical and beautifully human urges dominate our decision-making. We don’t generally learn from mistakes; we think ‘next time it will be different’. Even when faced with overwhelming statistical and analytical evidence, we ignore it, imagining the odds that apply to other people do not apply to us. The National Lottery, with its ‘It could be you’ slogan, trades on this. But it’s not just the average Joseph or Mary on the street who takes irrational risks.
Consider those who gamble on horses.
Over the Christmas season we Irish will have gambled millions on horses. Interestingly, professional gamblers in Ireland display an amazing weakness for backing an Irish horse even when the form tells us a foreign horse has a better chance of winning.
This irrationality perplexed me a few months ago, so in order to explore and find out more about it, I visited one of the most interesting and dynamic workplaces in the country. It is one of the few companies in Ireland employing mathematic graduates (so the Maths students out there, listen up). It is not the R&D department of a large foreign, tech based multinational, nor is it the academic hotbed of one of our aspiring fourth level universities. It is the headquarters of Paddy Power — the bookie – in Clonskeagh.
The quantitative or “quants” department of the Paddy Power operation is a fascinating place. Up in “Power Towers” young mathematics boffins apply probability theory and statistical analysis to the huge amount of data gleaned from bookies to assess and price risk.
In order to get a handle on human behaviour and rationality, I asked the good people at Paddy Power for figures on Irish betting patterns, and the data confirmed what we all probably suspected: that we are deeply irrational. In Paddy Power’s shops on the main streets of most Irish towns and cities, the average Irish-trained runner in a race in the UK takes 21 per cent more of the book than an equivalent UK-trained runner. The figures from Paddy Power’s online, phones and mobile business — by far the fastest-growing side of the business — are even more remarkable: the average Irish-trained runner, competing in a race in the UK, takes 24 per cent more of the book than an equivalent UK-trained runner.
If the guys who read the form and calculate the odds are so irrationally driven by emotion, what hope is there for the rest of us?
Our irrationality has profound implications for the way the economy works. It also might shed a bit of light on the next moves in the Irish economy.
When the economy is thriving, we believe that things will continue to go well and we get overly exuberant. When things are going badly we become overly pessimistic, overly self-doubting, and gripped by depression, angst and insecurity.
In the real world it is those who behave irrationally, not rationally, that actually make money. In recent years investors who made money are those who sell when everyone else is buying and buy when everyone else is selling. They are the exceptions; the norm is the rest of us. So the exceptional ones behave in the way economists like to think the rest of us do, and the rest of us behave the way economists think is the exception.
This dilemma at the heart of modern economics was well summed up by J. P. Morgan — the American banking titan of the early twentieth century and a man who had seen a number of booms come and go — who understood this irrationality and caught the essence of the madness of a boom when he noted that ‘Nothing so undermines your financial judgement as the sight of your neighbour getting rich.’
All this implies that much economics as it is taught at present in the Leaving Cert and in our universities has little or nothing to do with human behaviour as we know it. This is a big challenge for economics because many economists purport to have some insight into the complex field of human behaviour and this insight gives them the confidence to predict the future.
So the next time you read forecasters announce confidently that such and such a series of events will come to pass in the next year or two, be warned they are basing this on rationality, when we know that we human are beautifully and gloriously irrational.
Happy New Year.
David McWilliams’ new bookÂ The Good Room is out now.