The Case for Meta-Economics Pt. 2: Kwak’s Commentary on Thaler

James Kwak, along with former IMF chief economist Simon Johnson, writes one of the leading blogs on financial reform, Baseline Scenario.   Founded after the financial crisis of 2008, Baseline Scenario is mostly devoted to examining proposals for financial reform and urging legislators, central bankers and government leaders to reduce systemic risk to the banking system by breaking up very large banks that are “too big to fail”.  Kwak and Johnson are highly critical of the current form of proposals in the US Congress and advocated for by the Obama Administration as not going far enough in limiting the power of very large banks, which, because of their size, are able to hold governments and taxpayers hostage if they make bad bets on investments.   Among advocates of rigorous financial reform there is an interesting dispute between those who see bank size as a crucial factor while others are less concerned about the size of banks, a controversy I will take up at another point in time.

Kwak, Berkeley Ph.D. in European history, a software entrepreneur, former McKinsey consultant, and now studying law at Yale, has written a recent post critical of an article by Richard Thaler in the New York Times.  Thaler is one of the two or three leading economists and psychologists associated with behavioral economics and behavioral finance, new fields within economics that attempt through empirical study to examine how people make economic decisions.  Behavioral economics has come to challenge the dominant assumption in neoclassical economics that people are rational “utility-maximizers”.  While rational economic man has not been fully displaced from the structure of economics, behavioral finance is now considered to offer a “respectable” alternative to the assumption of purely self-interested rationality.

While a number of people have drawn the parallel between the Deepwater Horizon blowout and the 2008 financial blowup, Thaler’s Times column suggests that both with BP and the financial collapse we are tapping into a common cognitive problem that people have in assessing low probability risks.  Additionally Thaler feels that complex technology, sometimes beyond the ken of leaders, and diffusion of responsibility via complex inter-corporate partnerships interact with this cognitive difficulty that we have in preparing for unlikely events.  Thaler points out, in an interview in an an accompanying podcast on the Times website, that partners in these multi-company alliances have varying interests which don’t necessarily align with each other or with the common good.  Thaler’s prescription, though not stated clearly and strongly, is for regulators to require higher levels of insurance, where the insurers then would be incentivized to oversee operations.

Though not in principle opposed to the idea that people are bad at assessing risks and that rational economic man shouldn’t be assumed by economists, Kwak in his response takes issue with the way that Thaler’s thesis can be used to whitewash the very specific risks involved with large corporations that have incentives to maximize profits and externalize costs onto the population at large and governments.  Kwak points out that these “cognitive biases” within these companies almost always go the way of minimizing costs and maximizing profits (very much like rational economic man by the way).  Kwak also questions that one can personalize the composite behavior of corporations as he sees Thaler doing.  Kwak sees far more intentional rather than inadvertent minimization of risk in both the culture of large Wall Street financial institutions and BP.  Kwak, an advocate for much more stringent regulation of the financial industry, sees no way out of a return to more stringent external regulation by government.  While Thaler does not come out against regulation, his analysis tends to excuse the specifically corporate blindness to risk in the face of a structure of incentives and a regulatory culture that looks the other way.

Necessarily Creative Interdisciplinary Borrowing

Both Thaler’s and Kwak’s views on the common elements between the BP disaster and the financial crisis require the integration of frameworks and elements from outside of traditional economics.  Thaler’s view draws from cognitive psychology and organizational theory to help explain how our ability to assess economic risk became distorted in situations involving high technological complexity, low-probability events, and split organizational structures and incentives.  Kwak introduces a political discourse (one could say political science though this is not explicit) of power and power differences and a re-valuation of the now conventional economic theory of externalized costs, where externalization is the norm  rather than the exception.

Kwak and Thaler might agree on the individual “nudges” (Thaler co-authored the influential book “Nudge” with Cass Sunstein) or circumscribed regulations but Kwak suggests that overall there is a fundamental lack of government oversight and authority in our current system which were instrumental in both the BP spill and the financial crisis.  Thaler suggests that with a few minor tweaks, the corporations will “regulate themselves” by making sound assessments of risk.  Kwak suggests that there is the need for an entire cultural shift in business backstopped by a strong government regulatory culture.  There is then a fundamental philosophical and analytic difference between the two positions despite what might be some areas of agreement.

While I don’t want to argue out this particular dispute in this context, I am using this as an example, and perhaps not the best example, of smart, thoughtful people (Thaler and Kwak) bringing in a mixture of disciplinary tools in to solve some of the gravest problems of our times.  This “ad-lib” mixture of tools is a sign of personal erudition and analytic flexibility in assessing the reality of a situation but it leaves us not being able to compare their respective positions (not diametrically opposed by the way).  The contest, such as it is, between these two somewhat competing positions, is then consigned to the level of rhetoric:  with which account does  a reader feel more sympathy?  There is a comparison of apples and oranges.

Towards a Meta-economic Framework

My conception of a meta-economic framework could include as “compulsory” a consideration of some of the interdisciplinary elements as well as assumptions which both Thaler and Kwak (as well as others) introduce.  This may make some writing  less “fun” to write and “essayistic”, but it might serve the public better to be able to choose between arguments if assumptions, data, and analyses could be compared side-by-side.   A meta-economic framework would compel writers/”scientists” in this area to consider the vital connections between one disciplinary area and the immediate proximate causes that originate outside that discipline but impinge upon their chosen topic.  Aren’t these issues a matter of life and death, requiring a more serious engagement with reality?

As an example, Thaler might state or declare in some form that “I believe that corporations can accurately assess risk with the right alignment of corporate interests within and among corporations”  and “I believe corporations can share the characteristics of individual people in their ability to assess risk”.   Kwak on the other hand might state, “I believe internal controls will often be insufficient to control speculative excess and the misalignment of incentives within large oligopolistic corporations”.

A joint framework that encompasses both Thaler’s and Kwak’s “narratives” would include cognitive ability to assess risk, ability by economic actors to internalize ethical standards, relative autonomy of corporations vis a vis government, role of corporate internal group dynamics, employee performance metrics, operational complexity, alignment of interests in industry partnership “ecosystems”, and dominant government ethic of and power to regulate the industry in question.   If each author, this is maybe assuming a longer form of exposition perhaps, had touched upon their views of each of these dimensions, then readers would see both the weaknesses and strengths in their “models” for each of these debacles as well as whether they both can be analyzed together meaningfully.

While some may throw up their hands and say:  “we can’t consider every factor!”, I would counter that we clearly are in need of an analytic framework that guides us to either more comprehensive or different points of focus than the frameworks we have inherited prior to either the financial meltdown of 2008 or the BP blowout of 2010.  I am proposing what I am calling a meta-economic framework as a “workspace” to build that framework from the tools of economics and related disciplines.

About Michael Hoexter
I'm a clean energy marketing and policy strategist and consultant based in the San Francisco Bay Area.

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