For roughly two decades, the new science of behavioral economics has been challenging what economists call rational choice theory. Rational choice theory described that primate species called Homo economicusEconomic Manas rational, profit-maximizing, and efficient in making choices. When faced with a decision, the theory held, we carefully consider the value of an outcome and make a rational decision about the most efficient course to take to maximize the utility, or profit, of that outcome.
But research in behavioral economics has revealed that many, if not most, of our economic choices are driven not by rational calculations but by deep and unconscious emotions that evolved over the eons. Among these irrational emotions is risk aversion, a psychological effect that is actually part of the reason that financial markets work so well. People are more averse to risk than traditional economics would dictate, and that restraint helps keep most speculative market behavior in check.
As everyone knows by now, many of our major financial institutions werent nearly averse enough to risk over the last decade and a half. In seeking quick and carefree profits, along with trying to appease politicians pushing for wider homeownership, they tossed all restraint out the window, with devastating economic consequences. How did this happen, and how can we keep it from happening again?
Imagine that I give you $100 and a choice between (A) a guaranteed gain of $50 and (B) a coin flip, in which heads gets you another $100 and tails gets you nothing. Do you want A or B? Now imagine that I give you $200 and a choice between (A) a guaranteed loss of $50 and (B) a coin flip, in which heads loses you $100 and tails loses you nothing. Do you want A or B? The final outcome for A in each scenario is the same (winding up with $150); so is the final outcome for B (an even chance of winding up with $100 or $200). So rationally, whether you are in the first scenario or the second, you should make the same decision, which is what rational choice theory predicts.
But behavioral economists have discovered that most people choose A in the first scenario (a sure gain of $50) and B in the second (avoiding a sure loss of $50). Even though there is no rational difference between having $100 and a sure gain of $50, and having $200 and a sure loss of $50, there is an emotional difference. That emotion is risk aversion, and thousands of experiments have demonstrated precisely how averse to risk we are: on average, most people will reject the prospect of a 50/50 probability of gaining or losing money unless the amount to be gained is at least double the amount to be lost. Losses, it turns out, hurt twice as much as gains feel good, and it is our emotionsnot our reasondriving our risk-taking decisions. All other things being equal, only when the potential payoff is more than double the potential loss will most of us take the investment gamble.
So deep and powerful an economic emotion is this aversion that it may be an evolved trait. Food is probably at the root of it. Before human beings domesticated plants and animals, our nomadic ancestors had to hunt and forage to survive, and food was so scarce that hoarding was necessary for survival. Those individuals who valued food the most were more likely to survive and thus pass on their genes for hoarding behaviorand its corresponding emotion of valuing highly what is hoarded, whether food or something else.
Though risk aversion and its attendant fear of loss seem irrational by traditional economic standardswe tend to think of emotion as antithetical to reasonwhen allowed to operate, theyre an important reason that financial markets usually work so well. Interfering with them can wreak havoc.
Though the financial crisis is complex and has many explanations, one of its primary causes involves Fannie Mae and Freddie Mac, the nations largest guarantors of home mortgages. Recall that Fannie and Freddie are government-run organizations that do not make loans directly to customers; rather, they buy loans from the banks that make those loans directly. In spring 1999, Fannie and Freddieunder pressure from the Clinton administrationincreased their portfolio of loans to lower- and moderate-income borrowers from 44 percent to 50 percent by 2001. That meant granting loans to higher-risk customers.
Now, theres nothing wrong with corporations and institutions taking higher risks, so long as they adjust for it by charging more. The higher price acts as a risk signal to both buyers and sellers, thereby dialing up their emotion of risk aversion. Thats what Fannie Mae was already doing, in fact: when it purchased loans that banks made to high-risk customers, it bought only those that charged 3 to 4 percentage points higher than conventional loans. But under the new program, Fannie would buy high-risk mortgages that were only 1 point above a conventional 30-year fixed-rate mortgage (and that added point would be dropped after two years of steady payments). In other words, the normal risk signal sent to high-risk customersyou can have the loan, but its going to cost you a lot morewas removed.
And risk aversion cant operate, of course, without a risk signal. Lower the risk signal and you lower risk aversion. The result helped give us todays financial crisis. Similarly, the $700 billion economic-recovery package will only make matters worse because it, too, will short-circuit our normal aversion to risk. The package signals to the marketplace that if the system fails, the government will bail it out. Clearly, theres no need to be risk-averse when Uncle Sam will cover your losses.
An appropriate analogy is the world of sports, in which athletes do their best to win games within the rules established by each sports governing organization. Ordinarily, the rules against cheating reinforce the instinctive risk aversion of athletes, who dont want to take the chance of being caught. But when sports governing bodies either relax the rules or fail to enforce themthink of steroids in baseball or doping in cyclingit signals to athletes that there is little risk in pushing the boundaries of the sport. Diluting their risk aversion encourages some to game the system, and once the top competitors do it to get a slight edge over their immediate competition, everyone else has to do it just to compete. The result is a catastrophic collapse in the sports integrity.
Similarly, when the government intervenes in the natural dynamics of the marketplace by, say, encouraging corporations to relax the rules of financial transactions, and then signals to them that if the system fails it will bail them out, it tells market players that they face little risk in pushing the boundaries of the market. Lowering financial risk aversion encourages boundary-pushing, and once the top corporations do it, everyone else has to do it just to compete.
The purpose of capitalism, we unfortunately need to recall, is to make a profit. Low risk-taking typically results in slow and steady profits, whereas high risk-taking can produce both high profits and steep losses. By entering the business of risk protection, the government has reconfigured the economic game: in profits, were capitalists; in losses, were socialists.
Lets be brutally honest. The CEOs, CFOs, and COOs of the Wall Street financial giants who signed up for our new corporate welfare program are now welfare queens. Theyre on the dole. In an ideal world, they would all be put on a very public welfare-to-work programas in the welfare-reform movement of the 1990sthat tethered salaries directly to the amount of money paid back, with interest, to the people who earned the money in the first place: taxpayers. The corporate leaders could even appear on a new Fortune 500 list, ranked by how much of our money they had returned.
What would help ameliorate future financial crises? The government should not be in the business of hiding real risks through political imperatives, or of insulating corporations from the risks that they have freely taken. Doing so confounds the normal risk signals that keep the market in balance. For risk aversion to keep markets working, people and corporations have to be allowed to assess real risks and to fail if they take inappropriate risks. Only the people who produce wealth can properly assess how best to risk it in future investments. The Warren Buffetts of the world can do that. The Ben Bernankes cannot.
Michael Shermer is the publisher of Skeptic, a monthly columnist for Scientific American, an adjunct professor in the School of Politics and Economics at Claremont Graduate University, and the author of The Mind of the Market.