A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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The Engine of Capitalism
It might just be delusional optimism, says Daniel Kahneman.
28 October 2011
Thinking, Fast and Slow, by Daniel Kahneman (Farrar, Straus and Giroux, 512 pp., $30)
Why are we in a recession? Taxes are too high, say conservatives and free-marketers; thus, entrepreneurs have no incentive to invest or create new jobs. Demand is too low, say liberals: if wages were higher—whether paid by private employers or subsidized by government—consumers would buy more, and entrepreneurs would then produce more and recruit new employees. The dispute between supply-side and demand-side policies has divided economists and political parties for a generation, right down to geography: supply-siders tend to be freshwater economists, with their capital at the University of Chicago, while Keynesians tend to be saltwater or coastal economists, predominating at Harvard and Yale. Still, all economists think within the same broad paradigm and share the same theoretical language, even when they denounce one another. The internal contradictions within any science remain confined within the limits of an established consensus.
But all bets are off when an outsider intervenes in a field. This kind of transgression, quite common in the history of science, sometimes succeeds in producing a paradigm shift. And it is what Daniel Kahneman and the late Amos Tversky, both psychologists with no background in economics, achieved. In 2002, Kahneman received the Nobel Prize in Economics—the only non-economist ever to earn that honor—for his work on judgment, decision-making, and well-being. Kahneman and Tversky are widely credited with founding a new discipline: behavioral economics, which studies the impact of human psychology on economic life.
Behavioral economics may be not as revolutionary as it first appears. Adam Smith, after all, was a moral philosopher who developed a defense of free trade based on his observation of human nature. In The Wealth of Nations, Smith explains how the baker makes bread not because of generosity but because of self-interest, or—to use Smiths own words—self-love. This self-love, according to contemporary free-market economists, remains the driver of economic growth. For his part, John Maynard Keynes, neither a free-market apostle nor an anticapitalist, wondered why some of us—a minority, to be sure—would risk starting a business instead of pursuing safer employment. He called the psychological force behind entrepreneurship animal spirits.
So both Smith and Keynes understood the connection between individual initiative and the broader economic system. Both started from human nature as it is, holding no illusions about creating a new, better man who could foster a fairer economy and a more just society. Only the heirs of Jean-Jacques Rousseau and Karl Marx imagined that man himself must be improved in order to improve society. Stalin and Mao, among others, would seize on such utopian ideas, inflicting suffering on an unimaginable scale.
Kahneman does not contradict Smiths self-love or Keyness animal spirits, but he elevates them from intuitions into something like hard scientific evidence. As his important new book Thinking, Fast and Slow demonstrates, economic behavior can be better understood through scientific and psychological experiments. Most of the book describes the psychological experiments that Kahneman and his colleagues conducted to understand how people judge and decide. Kahneman concludes that our minds are divided into two very different operational systems: System One is fast, intuitive, and emotional, while System Two is slower, more deliberative, and more logical. The former can result in erratic decision-making and even in compulsive behavior, like buying what we dont need; the latter leads to slow, deliberate choices. In daily life, we constantly and intuitively shift from one system to the other, depending on circumstances; but external incentives—well understood by marketing experts—can activate one system against the other.
Kahnemans theory is in tension with another influential economic and psychological doctrine: rational-action theory, or RAT, whose leading proponent is University of Chicago economist Gary Becker. According to RAT proponents, people behave as if they were rational, whether in their personal lives or as economic actors. On this view, markets are generally rational and efficient, while government interference means less rationality, less well-being, and less happiness in society. Yet if RAT is true, behaviorists ask, how can we explain manias, bubble speculation, and self-defeating choices—none of which, moreover, depends on government? Becker and other RAT theorists accept that the market may not be fully rational, but they dont believe that the government is any more so. Governments, after all, are also made up of individuals acting in their own interests (or, for that matter, acting under the influence of Kahnemans System One).
Readers more interested in economics than in pure psychology will find a chapter called the engine of capitalism particularly striking. That engine, writes Kahneman, is optimism, both a blessing and a curse. Statistics and lab experiments show, he says, that human beings tend to exaggerate their ability to forecast the future. Government overconfidence can lead administrations to consider their goals more achievable than theyre likely to be; personal overconfidence has many pitfalls, but it can also lead the most optimistic among us to become entrepreneurs.
The chance that a small business will survive for five years in the United States is only about 35 percent. But entrepreneurs simply dont believe that such statistics apply to them. Surveys show that on average, they estimate their chances of success at 60 percent—almost double the statistical reality. One benefit of an optimistic temperament, of course, is that it encourages persistence in the face of obstacles. Optimists also tend to be charismatic leaders, able to motivate coworkers. Entrepreneurial delusions, as Kahneman calls them, energize much business activity and spur the economy as a whole. An absence of delusions, therefore, would lead to less growth, innovation, and risk-taking. Excessive, even unrealistic, optimism plays a crucial role in generating prosperity.
Entrepreneurial delusion becomes a curse, though, when it leads overly optimistic CEOs to make bets with other peoples money. The damage is compounded when the media make celebrities out of business leaders. Statistics show that fame increases delusion and fast-thinking, encouraging ever more irrational risk-taking. Fame and delusion also work their effects on the so-called experts whom the media ask for predictions about the future. In one of his many experimental surveys, Kahneman shows that six in ten forecasts made by pundits tend to be wrong. A nonexpert would be wrong only half of the time, according to the laws of statistics. Why are experts apparently less reliable than the common man? As Kahneman explains, the experts are often prisoners of rigid theories that prevent them from absorbing new information and understanding global changes that dont fit into the framework. Yet the authentic media-savvy pundit, says Kahneman, possesses a unique talent to rationalize and survive his own errors. The true culprits, he adds, arent the experts but the media, which expect prophecies. The truth is that the economic world is too complex for prediction. This is why central government planning cant work: too many parameters are in play, more than any theory or any thinker can control. The spontaneous order of the free market—as Friedrich Hayek described it—brings far better results.
Can training overcome overconfidence? System One thinking can be tamed but not vanquished, Kahneman believes. The question is how to introduce a dose of slow, System Two thinking into the entrepreneurs fast mental world. Kahneman, with the collaboration of another psychologist, Gary Klein, proposes the premortem as a partial remedy. The procedure is simple: when an organization has almost come to an important decision but has not formally committed itself, decision-makers should conduct an exercise: Imagine that we are a year into the future. The outcome was a disaster. Take five minutes to write a brief history of that disaster. In doing so, they may well discover that their decisions had been made too hastily, without sufficient deliberation. The premortem is no panacea, but it might reduce the biases of uncritical optimism. And while Kahneman doesnt say so, the premortem should be compulsory for delusional governments.
Guy Sorman, a City Journal contributing editor, is the author of Economics Does Not Lie and many other books.