In the next installment in our column from top economic commentator and What’s Next? author Lyric Hale, she discusses the recent US debt ceiling crisis and analyses how economists react in the face of uncertainty. She also examines the role of emotions in the decision making process, citing the recent impasse between the Democrats and Republicans and the effect that these decisions can have on a global level.
Article by Lyric Hughes Hale
An exhausted President Barack Obama announced on Sunday that the “cloud of uncertainty” over the US debt ceiling had lifted. Only last week, as markets faltered, Intrade had placed odds on this happening at less than 50%.
While the president was speaking, I was attending the closing night of Chinglish at the Goodman Theater in Chicago. It was brilliant, hilarious, and will soon be opening on Broadway. Styled as a comedy, at heart it is a serious play about the cultural gulf between the world’s two most important business partners, China and the United States. As I watched the misunderstandings between the Chinese officials and the Western businessmen, I could not help drawing comparisons with the divisive drama in Washington, and the difficulties of people from different sides and cultures trying to understand and work together. Onstage all seemed lost, and then (spoiler alert here) in spite of irrationality, personal agendas and grandstanding, it comes right in the end. The big business deal is made because of the human relationships that evolved through these trials. In other words, guanxi, a kind of socially-mediated risk management.
The various ways people make business and economic policy decisions, and deal with financial uncertainty are topics we tackle in our book, What’s Next? In his provocative chapter, “The Human Side of Investment Decision Making” Thierry Malleret discusses the new field of neuroeconomics. In an increasingly complex, risky and uncertain world, he describes how we make faulty decisions based upon a combination of proximate data and “cognitive illusions”:
We find it very difficult as human beings to make rational decisions based on the objective assessment of several possible alternatives. In fact, our decisions are subjective and profoundly influenced by our emotions, beliefs and feelings. As such, we often disregard the available information, or misinterpret it.
In an intriguing paper focusing on the misallocation of the principles of physics in economics, Andrew Lo and Mark Mueller at the MIT Sloan School of Management evaluate the role of emotion in economic behavior, and propose a taxonomy in order to match risk management to appropriate levels of uncertainty. They define risk as that which can be fully calculated by economists through their use of models and quantitative analysis. Uncertainty embodies all other kinds of randomness.
Level 1: Complete Certainty—mathematics and physics
Level 2: Risk without Uncertainty—the honest casino with known odds
Level 3: Fully Reducible Uncertainty—unknown probabilities, scientific research
Level 4: Partially Reducible Uncertainty—economics and psychology
Level 5: Irreducible Uncertainty—religion and philosophy
Level 6: Zen Uncertainty—the unknown unknowns
Lo and Mueller theorize that humans adapt to uncertainty through a combination of rational thought and emotion.
From an evolutionary perspective, emotion is a powerful tool for improving the efficiency with which animals learn from their environment and their past. When an individual’s ability to experience emotion is eliminated, an important feedback loop is severed and his decision-making process is impaired.
How can these two approaches to dealing with market uncertainties be reconciled? On a national level, one way to create certainty is through fiat, another is through open debate, however painful.
The leading lady of Chinglish, Vice Minister Xu, is accustomed to a self-confident central authority. She derides the US as unpredictable. When the Ohio businessman she is dealing with says China is strong compared to the US, she sees this as an incomprehensible example of a strong nation allowing itself to project weakness. Watching us ride to the edge of the precipice unnecessarily in their view, People’s Daily called US handling of the crisis “irresponsible” and “immoral”, and called the US democratic system a “farce”.
Ideologically, I stand apart from the Tea Party people, and do not believe that they appreciate the damage they might have caused. I have been trying to find out how many of them hold US passports in order to explain their disregard for world opinion. But as I heard analysts forecast how bills might or might not get paid, saying that of the billions of funds that were needed in August, only 60% would be received in revenue, my Midwestern perspective kicked in and I thought well yes, that is part of the problem, isn’t it?
We are saving more as individuals, but as a country, we are spending a lot more than we are taking in and we are going to have to deal with that now, or later. The fact is, we do owe the Chinese a trillion dollars and that is a card the Chinese can play, at least politically if not practically.
The debt crisis had positive results on a variety of levels. As Americans, we have learned from the economic discussion that has taken place. I did not know about the no-default clause in the 14th amendment, which was enacted to avoid default on Union debts after the Civil War. I did not realize that President Reagan had raised the debt ceiling 18 times. I was impressed by the quality of the debate between our Illinois Senator Dick Durbin, and John McCain. And it is possible that if much of the divide in Washington has been due to legislators who spend minimal time in the capital, this weekend at least they got to know each other a little better. Guanxi again!
We deserve criticism for taking this debate so far to the edge. However we need to acknowledge that democracies are inherently less predictable than single-party governments, which must limit access to information in order to preserve authority. Which brings me to the role of transparency in uncertainty, and a positive forecast for the long-term viability of the US economy. Our system is fractious, and our disagreements are played out in public. As President Obama said, “it might not be pretty, but it works”.
In contrast, the New York Times reports that China is clamping down on press coverage of the recent bullet train crash. Lack of transparency by governments will create less confidence and greater uncertainty over time. Paradoxically, even unruly dissent provides freer flows of information to the markets, increasing stability.
On an individual level, better understanding of how our brains work when faced with uncertainty, and how this influences our decisions, will help us navigate the future. But in the rush to eliminate both risk and uncertainty, it might be wise to remember Von Clausewitz’s famous admonition. “Although our intellect always longs for clarity and certainty, our nature often find uncertainty fascinating.”
It has been a fascinating week.
What’s Next? Unconventional Wisdom on the Future of the World Economy by David Hale and Lyric Hale is available now from Yale University Press.