Alan Greenspan still doesn't get it.

When the former chairman of the Federal Reserve appeared before a congressional committee last October, he was contrite. "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief," he said.

For behavioural economists -- imagine economics leavened with psychology -- it was a bittersweet moment. For many years, they had been urging their orthodox colleagues to abandon the assumption of rationality that is the foundation of modern economics. It's wrong, they insisted. And it's dangerous.

Why dangerous? Many reasons. One was explained this week, in a blog entry about the financial system that appeared on the Financial Times website:

"The extraordinary risk-management discipline that developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics," the author wrote. "It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators. But in August 2007, the risk-management structure cracked. All of the sophisticated mathematics and computer wizardry essentially rested on one premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring and managing their firms' capital and risk positions. For generations, that premise appeared incontestable but, in the summer of 2007, it failed."

See the assumption of rationality? It's in the self-interest of the clever people on Wall Street to avoid going bust, so they will identify risks and not expose their institutions to more than they can handle. In this way, the financial system as a whole will be protected.

Thus, government regulation is not required.
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Unfortunately, those clever people on Wall Street did expose their institutions to more risk than they could handle. The financial system as a whole was not protected. And government regulation was required.

The author of the passage I just quoted is none other than Alan Greenspan. So has "the maestro" (remember when people called him that without sneering?) learned his lesson?

Apparently not. "It is clear," Greenspan wrote in explaining Wall Street's catastrophic failure, "that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk-product design, were too much for even the most sophisticated market players to handle properly and prudently."

Sure, Wall Streeters were clever and they had computers and guys with PhDs in mathematics and whatnot. But that stuff was so complicated!

When Greenspan made his famous admission to Congress last October, many observers hoped he was acknowledging that the assumption of rationality -- the assumption on which he constructed his view of economic reality -- is wrong. But this lame explanation suggests that Greenspan, like the Bourbons, has forgotten nothing and learned just as much.

Now, if this were only about one retired economist, it wouldn't be worth our attention. But banks, regulatory agencies, and economics departments are filled with junior Greenspans. If the original hasn't learned from this disaster, we have to worry that the juniors haven't either -- and that they will carry on using the thinking that was a major source of the disaster we are struggling with now.

The strange thing, though, is that it's actually hard to find economists who admit to thinking along these lines. An assumption of rationality? Good heavens, no! They never admit to being so unsophisticated. Of course they know people are emotional and occasionally irrational. That "Homo economicus" stuff is a caricature of economics, they insist.
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In his Financial Times piece, Greenspan himself tries to show that he understands humans aren't Vulcans. He talks about "euphoria," "fear," and "fever." And of course he mentions the phrase "irrational exuberance," which he coined in 1996.

But none of this is serious psychology. It's the pop variety, the stuff that fills business commentary and invites us to imagine bankers and traders punching the air and shouting "woo hoo!" or panicking like gazelles as their rumps are raked by lion claws.

This is all ludicrous. In finance, the decisions that matter are almost always made by calm people in quiet offices. It's not the fierce power of surging emotion that generates irrationality. It's the subtle influence of cognitive and social biases -- influences that are so subtle they typically don't register in consciousness at all.

Some orthodox types know the research literature but refuse to treat it as anything but after-dinner entertainment. "Irrationality is to be found in the cognitive quirks that we owe to the human brain having evolved in a very different environment from our present one," wrote Richard Posner in a review of Animal Spirits, by George Akerloff and Robert Shiller. For example: People believe "a price of $5.99 is meaningfully less than $6.00."

This sort of thing may be exploited by merchants, Posner wrote. But "these quirks do not explain depressions."

The explanation for my depression is that sentence, and others like it.

In recent years, we have seen vast numbers of sophisticated people engaging in spectacularly irrational behaviour. And now the whole world is suffering for it.

If this experience cannot loosen the dead hand of economic dogma, I'm not sure anything can.

You can contact Dan Gardner at the Ottawa Citizen.
E-mail: dgardner@thecitizen.canwest.com

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