The title of this book, [amazon_link id=”B005MJFA2W” target=”_blank” ]Thinking, Fast and Slow[/amazon_link], captures the fundamental point that we have two systems of thinking – Kahneman labels them system 1 and system 2. S1 acts automatically, doing things such as recognizing stock phrases, responding to sudden noises or unpleasant pictures, driving in easy conditions. It is the source of intuitions and emotional responses. It kicks in first, without us having any capacity to stop it. S2 is the deliberative system, making calculations or doing any non-obvious thinking, and is a fall-back system because it requires effort and energy (although tasks become less energy-intensive as one becomes more skilled at them). Kahneman describes it as ‘lazy’ – S2 won’t bother to get motoring if S1 appears to have found an adequate answer. Exercising self-control is also a S2 task, and fatigue, or alcohol, as well as cognitive load can diminish our self-control. If S2 is busy, S1 is more likely to successfully demand a piece of chocolate cake rather than an apple. (There is a handy summary of S1 characteristics on p105.)

Much of the book sets out (with touching, frequent reference to Kahneman’s deceased co-researcher Amos Tversky) the biases systematically uncovered by a decades-long programme of research into how we think. Most of these are now well-known. For example, priming effects are ubiquitous – reminders of money make for more selfish responses and a greater preference for solitude or distance, for example (p55). People are more readily persuaded by anything that reduces cognitive strain, so clear bold fonts that are either blue or red and printed on high quality paper with sharp contrast are literally more persuasive. So too if you use simple language and use constructions like ‘one person in a hundred’ rather than ‘1% of respondents’; the very word ‘percentage’ seems to inhibit rational thought (see p163).

An important principle of thinking is ‘WYSIATI’ – what you see is all there is. Our mind focuses on activated information, and any other information might as well not exist. “System 1 excels at constructing the best possible story that incorporates ideas currently activated, but it does not (cannot) allow for information it does not have.” (p85). S1 measures its success by the coherence of the story it creates from what is immediately available. When this is relevant to the thinking task at hand, the result is an impressive feat of intuition; otherwise, the result is one of the biases Kahneman documents, such as over-confidence, over-estimating the probability of rare events. The S1 insistence on coherence also makes us highly vulnerable to causal explanations, and rubbish at assessing randomness. People will often see patterns in genuinely random data, and greatly under-estimate the likelihood of random clusters – something that is ominously apparent in a number of court cases one can call to mind. It also means we have a strong hindsight bias, imposing largely illusory histories on the course of events, which often owes more to chance than is commonly acknowledged (see pretty much any business biography or history book).

In addition, S1 deals readily with averages but very poorly with sums, because it works by example not by calculation. Calculation is a S2 task taking a lot of energy (especially chocolate cake). As is now familiar from behavioural economics, the upshot is that we have some strong biases in probability calculations, summed up in the famous prospect theory.

There is an amusing section on the stock market, recounting Kahneman’s demonstration to fund managers that their performance was worse than chance alone would have delivered – duly ignored by his audience. As also pointed out by Nassim Taleb in his [amazon_link id=”0141031484″ target=”_blank” ]Fooled by Randomness[/amazon_link], most supposedly skilled investors have just been lucky. Kahneman comments, though, that: “The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions – and thereby threaten people’s livelihood and self-esteem – are simply not absorbed. The mind does not digest them.” (p216) I wrote in an earlier post about the consequences for expertise in any business where there are many ‘unknown unknowns’, including investing and economic forecasting.

The book does offer some good advice for dealing with S1. As well as the document design principles mentioned above, people’s behaviour can be changed by priming them – the instruction to ‘think like a trader’ shifts some people to S2 calculations. In groups, it is important to have someone who can offer an “outside view” given the natural tendency to under-weight the impact of extreme outcomes, and to fit stories to too little information (I have long done this in groups such as merger inquiries where lawyers will be scrutinising every step by asking one person in the group to play ‘devil’s advocate’ when we are near a conclusion.) The biases are not all bad, however. Business executives are almost delusionally over-optimistic, but if they were not there would be no enterprise and innovation.

The interplay between prospect theory and conventional economics is not, as Kahneman points out, a knock-out for the former. He describes the basic concepts of economics as ‘essential intellectual tools’, which in some circumstances predict behaviour better than prospect theory. What’s more, making decisions according to the pattern of risk-aversion for high-probability gains and low probability losses, and risk-seeking for high-probability losses and low probability gains will – over time – lead people to accumulate large expected losses compared to what their outcomes would be if S2 reigned supreme. S2 choices are more rational! Having said that, the existence of priming effects and reversals of preference do present a major intellectual challenge to economics.

It is, though, a challenge to which economists are responding with enthusiasm (see for example my post on this joint psychology and economics conference about scarce attention). Although the many critics of economics continue to perpetuate the myth that the subject depends on that chimera, the selfish hyper-rational individual, most economists I know no longer regard that set of assumptions as foundational to our subject. We are in the early days of a joint endeavour with psychologists and cognitive scientists to learn more about how real people make decisions and how that aggregates to social and economic outcomes. [amazon_link id=”B005MJFA2W” target=”_blank” ]Thinking, Fast and Slow [/amazon_link]is a brilliant contribution to that shared mission, and it will definitely be one of my top books of 2011.

[amazon_image id=”1846140552″ link=”true” target=”_blank” size=”medium” ]Thinking, Fast and Slow[/amazon_image]

In slight despair after reading the Sunday papers and reviewing the past few weeks in the Eurozone, I picked up Hyman Minsky’s [amazon_link id=”0071592997″ target=”_blank” ]Stabilizing an Unstable Economy[/amazon_link]. Minsky deservedly came back into fashion big-time in the immediate aftermath of the 2008 leg of the Great Financial Crisis. However, although his analysis of the inherently unstable financial dynamics of the market economy had stuck in my mind, his policy prescriptions had not.

The final chapters make for rather interesting reading. Minsky notes that Keynesian economics had never really been incorporated into policies. He viewed the usual alternatives of a small-government liberalized capitalism versus a big-government centralized version as a false dichotomy. “All that was assimilated from Keynes by the policy establishment and its clients was the analysis of an economy in deep depression and the policy tool of deficit financing.” (p324)

However, he is no fan of deficit financing albeit recognising its emergency role. Minsky’s own prescriptions could be summed up as:

Focus on full employment, and investment and growth will then look after themselves;

Price stability is essential;

Large scale government investment is a crisis-solution to a depression, which creates an inflationary bias if left in place long term. Government budgets need to be balanced;

A system of transfer payments that is too extensive is both too costly and socially destabilizing;

However, private markets, especially in finance, are economically destabilizing and need to be constrained by government interventions;

The competence of the state to administer is limited, and these interventions should be kept simple.

He ends: “There is no magic economic bullet; no single program or particular reform will set things right for ever.” (p326) Indeed.

This is not, I think, the impression that many people would have of Minsky’s conclusions, which run interestingly aslant the conventional approaches. They also concern long-term frameworks, and while a better approach to the underlying structures of the welfare state, the institutional framework of the economy and economic management are clearly necessary, it doesn’t help the Eurozone this week.

[amazon_image id=”0071592997″ link=”true” target=”_blank” size=”medium” ]Stabilizing an Unstable Economy[/amazon_image]

In this morning’s Guardian Zoe Williams has a feature explaining why she has given up the confection of fiction for the roughage of non-fiction books about the increasingly apocalyptic state of the economy. Her four top picks for current affairs books to read are:

[amazon_link id=”014104571X” target=”_blank” ]Whoops![/amazon_link] by John Lanchester (explains the Crash brilliantly)

[amazon_link id=”1846142393″ target=”_blank” ]The Return of Depression Economics[/amazon_link] by Paul Krugman (why the government has to sustain demand)

[amazon_link id=”0465051960″ target=”_blank” ]Power and Prosperity [/amazon_link]by Mancur Olson (the interplay between the economy and society)

[amazon_link id=”0857892797″ target=”_blank” ]Back from the Brink [/amazon_link]by Alastair Darling (the former Chancellor’s account of the torrid days of the Crash)

A great selection – the Olson is less well-known but well worth it. I’m a big fan of his work. I would add a few more suggestions

[amazon_link id=”0141003251″ target=”_blank” ]The Morbid Age[/amazon_link] by Richard Overy (cultural history of the 1930s)

[amazon_link id=”1906964440″ target=”_blank” ]When Money Dies[/amazon_link] by Adam Fergusson (the opposite fear to Krugman’s anxiety about what happens if governments don’t opt for deficit financing – what happened when they did, and monetised it; read this to understand the Germans)

[amazon_link id=”158648799X” target=”_blank” ]The Great Depression: A Diary[/amazon_link] by Benjamin Roth (an intelligent midwestern attorney lives through the 1930s week by week)

[amazon_link id=”0691118205″ target=”_blank” ]Essays on The Great Depression[/amazon_link] by Ben Bernanke (how the Fed chairman thinks about the situation – from his academic days)

[amazon_link id=”1846142571″ target=”_blank” ]The Big Short: Inside the Doomsday Machine[/amazon_link]

by Michael Lewis (alongside the Lanchester book, the most readable account of how we got here and why huge reform of finance remains a political necessity)

Interestingly, Richard Overy’s history of the 30s recounts the growing appetite for understanding that Williams expresses in her article. The New Left Book Club was founded and succeeded brilliantly, people read newspapers, joined societies, flocked to libraries and public meetings. We’re seeing the same phenomenon now with blogs and websites proliferating, book clubs turning to non-fiction, lectures packed out with large crowds, enrollments for courses in economics up, massive interest in the business and political news. Serious pursuits for serious times.

Any other book suggestions here are welcome.

[amazon_image id=”0141003251″ link=”true” target=”_blank” size=”medium” ]The Morbid Age: Britain and the Crisis of Civilisation, 1919 – 1939[/amazon_image]

I’m two-thirds through Daniel Kahenman’s [amazon_link id=”B005MJFA2W” target=”_blank” ]Thinking, Fast and Slow[/amazon_link], and will be posting a review early next week. It is one of the best books I’ve read all year, and it will change the way I think and work. There are not many books that change anybody’s mind about anything – most of us read to get support for the thing we already believe – so that’s already pretty high praise!

As a curtain-raiser, I wanted to quote from a section where Kahneman describes how he resolved a disagreement with Gary Klein, and advocate of ‘Naturalistic Decision Making’ who argued that the evidence indicated experts, thanks to their experience, are able to make intuitive and speedy decisions about problems that are better than the decisions non-experts would make. Kahneman (and his co-author Amos Tversky) argued that, on the contrary, experts are prone to all kinds of psychological biases including over-confidence and the failure to take account of evidence that contradicts their views, and do no better than non-experts.

In this book, Kahneman writes:
“We eventually concluded that our disagreement was due in part to the fact that we had different experts in mind. Klein had spent much time with fireground commanders, clinical nurses and other professionals who have real expertise. I had spent more time thinking about clinicians, stockpickers and political scientists trying to make unsupportable long-term forecasts. … He was more willing to trust experts who claim an intuition because, as he told me, true experts know the limits of their knowledge. I argued that there are many pseudo-experts who have no idea that they do not know what they are doing.” (p239)

Clearly Kahneman could add economists to his list. This isn’t the first call for economists to have more humility about the limits of what can be forecast, but it is one of the most forceful. More generally, this question of the context in which one is trying to make decisions seems to me to be an interesting aspect of behavioural economics – the kind of heuristics Kahneman describes in this book clearly apply in conditions of uncertainty with many ‘unknown unknowns’, but equally conventional and seemingly simple-minded economic models make very good predictions in other contexts; market/auction design is one of the success stories in economics. I think the boundary conditions are very interesting. This issue also underlines the urgent need to reintroduce uncertainty back into economics – as argued here recently, in a review of [amazon_link id=”0674057759″ target=”_blank” ]Capitalist Revolutionary: John Maynard Keynes[/amazon_link], the basic lesson we need to take now from Keynes.

[amazon_image id=”B005MJFA2W” link=”true” target=”_blank” size=”medium” ]Thinking, Fast and Slow[/amazon_image]

As a middle-aged, US-trained, European economist, I feel a natural sympathy for the middle-aged, US-trained, European economists floating into positions of power – a little like Mary Poppins, umbrella open, floating gently down from the sky to sort out the mess. Lucas Papademos, Mario Monti, Mario Draghi all seem like thoroughly decent, respected public servants, and one hopes fervently that their ascent will help restore calm to European financial markets, where inter-bank lending is drying up again.

The mini-trend does, however, raise the technocracy versus democracy question so powerfully raised by Daniel Bell in [amazon_link id=”0465097138″ target=”_blank” ]The Coming of Post-Industrial Society[/amazon_link] (in 1973):

“In a society which becomes increasingly conscious of its own fate, and seeks to control its own fortunes, the political order necessarily becomes paramount. Since the post-industrial society increases the importance of the technical component of knowledge, it forces the hierophants of the new society – the scientists, engineers and technocrats – either to compete with the politicians or become their allies. The relationship between the social structure and the political order thus becomes one of the chief problems of power in a post-industrial society.”

Written like a sociologist. But the book makes the point forcefully that the more complicated the economy and society, the greater the need for technical expertise in managing it, and the greater the tension with the growing presumption of democratic participation by all. Indeed, the technologies driving the social complexity are also driving the presumption that political participation by ordinary, non-expert folk will continue to grow. A financial system that has become a tangle of complex derivatives meets growing populism…. no signs that Bell’s dilemma is becoming any less acute, then.

A technocract parachuting in to the rescue