How did financial players lose sight of the economy?
One popular view is that the financiers involved in the economic crisis were evil human beings. Not only is this view incorrect; I worry that adapting it will not lead us to actually fixing the real problems in the market.
Here, it’s helpful to describe a set of experiments we have done with some MIT and Harvard students. [1]
We gave a large group of students a sheet of paper with 20 simple math problems, and gave them only five minutes to solve these problems. A third of the students submitted their sheets and got paid 50 cents per correct answer. Another third were asked to tear up their completed worksheets, stuff the scraps into their pockets, and simply tell the experimenter their score in exchange for payment - making it possible for them to inflate their score. The final third were also told to tear up their worksheets and tell the experimenter how many questions they had answered correctly, but this time, the experimenter wouldn’t be giving them cash. Rather, she would give them a token for each question they claimed to have solved. The students would then walk 12 feet across the room to another experimenter, who would exchange each token for 50 cents.
What is the point of all of this? We intuited that people could easily take a pencil from work without thinking of themselves as dishonest, but that they could not take 10¢ from a petty-cash box and feel good about themselves. In essence, we wanted to find out whether the insertion of a token into the transaction-a piece of valueless, non-monetary currency-would affect the students’ honesty. Would the token make the students less honest in tallying their answers?
What were the results? The participants in the first group, who had no way to cheat, solved an average of 3.5 questions correctly. They were our control group. The participants in the second group, who tore up their worksheets, claimed to have correctly solved an average of 6.2 questions. Since we can assume that these students did not become smarter merely by tearing up their worksheets, we can attribute the 2.7 additional questions they claimed to have solved to cheating. But, in terms of brazen dishonesty, the participants in the third group took the cake. They were no smarter than the previous two groups, but they claimed to have solved an average of 9.4 problems-5.9 more than the control group and 3.2 more than the group that merely ripped up the worksheets. This means that when given a chance under ordinary circumstances, the students cheated, on average, by 2.7 questions. But when they were given the same opportunity with non-monetary currency, their cheating increased to 5.9, more than doubling in magnitude. What a difference there is in cheating for money versus for something that is a step away from cash!
What lesson can we learn from this experiment about human rationality and the stock market? As it turns out, we humans are fantastic rationalizing machines. When we have an incentive to see the world in a certain way, we will see it that way. Any sports fan knows this very well; it’s very hard to see a close call that is against our team as being justified. What is more, when actions become less defined, removed from cash, or just fuzzy (think of watching a very small TV with a dirty screen or about complex financial products that no one really understands), our ability to justify our actions increases dramatically, and we are able to “bend” reality in a way that suits our selfish motivations.
This suggests that the people involved in the market meltdown are not evil-they are just driven by the same motives that would have played tricks on all of us had we been in their situation. The way to prevent such a meltdown from happening again is to make sure that the next generation of financial experts understands the importance of doing the right thing for their clients. Just as we don’t want judges to get a cut of the settlements over which they preside, it is also clear that we don’t want the financial experts to be biased by their own incentives.
[1] describe this experiment in more detail in Predictably Irrational.
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December 10th, 2008 at 1:00 am
Jeff, I recently bought the docudrama, ENRON, Smartest Guys in the Room, which I watched 2 nights ago with my 14 year old daughter who is living a world away from corporate life and the wheeling and dealing of the financial world. I was really interested in her observations…she said, she wonders if she herself wouldnt be tempted to exploit situations if there was a profit to be made and others were too stupid to cotton on, and asked me how I think I would act.
After gulping about the profoundness of this question, I realised that this innocent untainted kid was simply speaking the truth about human nature, especially smart people who get rewarded for success. A point proven through the experiments you referenced.
However, I question how we will magically raise another generation of ethical financial experts doing the right thing by their clients without a fundamental restructure of our DNA and cultural memes. Exploitation of situations plays to the dark side that’s in all of us, and the best way to counter that is having powerful checks and balances. Granted, that is not always foolproof, as the Arthur Andersen complicity - a failure of an armslength check - proved in the ENRON case. But I think we have to look at the whole of the system as we CANNOT rely on integrity of individuals alone.
January 7th, 2009 at 2:30 pm
January 7th, 2009 at 8:16 pm
I agree with Annalie that the base instinct of people won’t change simply because it is the “right thing” to do.
This is where the role of regulation/oversight could serve the greater good. Consider the case of the Financial Adviser vs. a Mortgage Broker. A Financial Adviser is expected to have a “fiduciary duty” to their client - and it is defined and enforced by the regulatory authorities. Historically, a Mortgage Broker has not borne that responsibility… and in some cases, requires no greater requirement than a willingness to call themselves a Mortgage Broker. Alas, even with oversight we can’t avoid the risk… only mitigate it and stop the most obvious violators.
Unfortunately, even with regulation, we creative and ingenious human beings find ways to ‘get er done” that may wind up hurting others. Call it pushing the envelope, delivering upon market demand, or innovation - we will always try to create new and inventive ways to generate revenue.
The financial players did what they do best - find new ways to generate revenue. Unfortunately, short term gains prevailed over long term objectives. I wonder if the landscape would be different if the board members of these financial players had acted upon their responsibilities to shareholders instead of being whores to increased revenue. It all looked so reasonable at the time….
February 12th, 2009 at 3:59 am
Defining ethics itself is a tricky thing. While the world seems to have become flat, it is full of complex webs of cultures and conflciting objectives. What is best for the company is not always best for the customer and vice versa. While we can definetely learn from mistakes of the past and think up additional checks; the world has and will belong to the fittest. Would it be possible to define \fittest\ to mean health, wealth and character in the future?