Behavioral Economics: The Big Short Part III, The DK Effect Part VI

In a pioneering experiment in economic behaviorism,* B.F. Skinner attempts to prove the theory of trickle-down economics **



In  our previous entry, we continued our exposition of the film The Big Short. We noted the role that the bond ratings agencies played in the spreading the financial virus known as collateralized debt obligations (CDOs), and their mutant offspring, synthetic CDOs, in the 2008 financial collapse. In this installment, we expand  our exploration of the Dunning-Kruger effect by delving into the related fields of behavioral economics and behavioral finance. And we document how the fraudulent  mortgage bond industry directly gave rise to the Tea Party.

Behavioral Economics

In the film The Big Short, Dr. Richard Thaler, author of Misbehaving: the Making of Behavioral Economics, identifies the key driver behind bubble psychology as the hot hand fallacy, an allusion to a basketball player on a hot shooting streak (with an assist from Selena Gomez; see previous entry). In the financial universe, it refers to the belief that because stocks and real estate have gone up in the past, they will continue to do so in the future. Okay, maybe with some dips and valleys along the way, but not enough to separate a True Believer from his or her’s God-given right to fabulous riches and a glorious retirement.

Behavioral economics can be defined as:

…the study of the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation. Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models cover a range of concepts, methods, and fields. Behavioral economics is sometimes discussed as an alternative to neoclassical economics. [cites omitted; emphasis mine]

Of the three prevalent themes underlying behavioral economics―heuristics, framing, and market inefficiencies―the ones that concern us here is framing.

Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely on to understand and respond to events…human beings are by nature “cognitive misers,” meaning they prefer to do as little thinking as possible. Frames provide people a quick and easy way to process information. Hence, people will use the previously mentioned mental filters (a series of which is called a schema) to make sense of incoming messages. This gives the sender and framer of the information enormous power to use these schemas to influence how the receivers will interpret the message.

Given that my ontological bias is rooted in The Urantia Book, permit me to share this excerpt from its 1.1 million word text concerning “the bounds of rationality” and framing  [emphasis mine]:

Partial, incomplete, and evolving intellects would be helpless in the master universe, would be unable to form the first rational thought pattern, were it not for the innate ability of all mind, high or low, to form a universe frame in which to think.…And while such universe frames for creature thought are indispensable to rational intellectual operations, they are, without exception, erroneous to a greater or lesser degree…

While the passage above concerns a general discussion of cosmology, it does reflect the relativistic nature of all thinking. As above, so below. It’s good to keep in mind that any attempt by a part to comprehend a whole, in this case the individual’s attempt to cognize the financial universe in which he or she is embedded, is problematic; i.e not absolute, subject to change. It also underscores what behavioral economics refers to as the “bounds of rationality.” People who violate those bounds are what we here at Urantian Sojourn like to call Teh Stupid and Teh Crazy. While I don’t think that the Wall Street banksters who brought us the financial collapse consciously engineered it, their unshakable belief in their own competency (a hallmark of the Dunning-Kruger effect) helped convince other “cognitive misers” to buy what they were framing, er, selling.

There is a scene in The Big Short where a discouraged Dr. Burry (who had predicted the collapse of the subprime loan industry some 4 to 5 years before it occurred; and is an example of an arbitrage participant mentioned in the section below), tells an employee to start liquidating some the fund’s other assets to pay the premiums due on their insurance swaps. The employee asks him whether his whole thesis about the subprime loan industry could be wrong. Burry replies that he just couldn’t see how―numbers didn’t lie in his world. But in contrast to The Street as a whole, he admitted being wrong was at least a possibility. It’s people who can’t even admit the possibility of being wrong that is the subject of the film’s epigraph:

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. –Mark Twain

Burry would have been proven correct a lot earlier if the market wasn’t as crooked as he subsequently discovered it to be. As firms like Goldman Sachs, which had underwritten a big chunk of his credit default swaps realized they were going to get crushed, they artificially kept the market alive as long as they could, frantically dumping their swap liabilities on any sucker they could find, including their own unsuspecting clients.

Behavioral Finance

The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants. Such errors affect prices and returns, creating market inefficiencies. The study of behavioral finance also investigates how other participants take advantage (arbitrage) of such errors and market inefficiencies.

Behavioral finance highlights inefficiencies such as under or over-reactions to information as causes of market trends and in extreme cases of bubbles and crashes. Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider behavioral finance, to be behavioral economics’ “academic cousin” and to be the theoretical basis for technical analysis.

Having dabbled in technical analysis (TA) over the years, that last sentence provoked an “aha” moment for me. I’d never bothered to look into the psychological underpinnings of TA, of why certain chart patterns correlated with significant price movements. It was enough that there exists a high degree of correlation between the two. From the perspective of behavioral finance, taking the pulse of the market in general or individual stocks in the particular is really a way of divining how investors are using their emotional and cognitive filters to “make sense of incoming messages.”

In addition to technical analysis, another approach to investing is fundamental analysis. Tune into any of the three major business news channels and you’ll be treated to an endless parade of “experts” framing that day or week’s trading activities with narratives that, on the surface, seem to explain what’s driving the market at any given time. But after a couple of decades of watching these people, I’ve concluded that a great deal of their “analysis” is simply designed to keep the rubes in the game by providing seemingly “rational” explanations for what are largely high frequency, computer driven trading schemes that use “dark pools” of money and others forms of subterfuge to separate investors from their money.

Other interesting psychological insights that behavioral economics and behavioral finance brings to the table include: the dynamics of  loss aversion―the tendency for people to strongly prefer avoiding losses than acquiring gains; the endowment effect―a hypothesis that people value a good more once their property right to it has been established, the curious tendency to value one’s own property over the identical property of another; and my personal favorite, conditional expected utility, defined as:

A form of reasoning where the individual has an illusion of control, and calculates the probabilities of external events and hence utility as a function of their own action, even when they have no causal ability to affect those external events.

What could be more devastating to a control freak than to suddenly realize that the basis of his or hers presumed control is an illusion? As in, mortgage bonds never fail? Stocks and real estate prices will rise ad infinitum? It takes a person with a special cognitive makeup to so staunchly believe in their own competence, while the world they helped create comes crashing down around their ears. Just what was going on inside the hamster wheel  brains of these Wall Street’s Masters of the Universe? Ask any of them whether they considered themselves “smart,” and no doubt the answer would be yes. I recently came by this definition of smart by neuroguy at the Big Orange in his diary titled “Dr. Ben Carson is not Smart.” Think of it as an inverse definition of Teh Stupid.

“Smart” is a multifaceted cognitive feature composed of excellent analytical skills, possession of an extensive knowledge base that is easily and frequently augmented, possession of a good memory, and being readily curious about the world and willing, even eager, to reject previously accepted notions in the face of new data. Being smart includes having the ability to analyze new data for validity and, thinking creatively, draw new insights from existing common knowledge. [emphasis mine]

Or as The Urantia Book puts it:

The true teacher maintains his intellectual integrity by ever remaining a learner.

Assigning Blame

There are any number of conventional explanations for the Great Recession. All may be true, as far as they go, and include the following:  it was another example of the greater fool theoryit was due to a lack of regulatory oversight by an underfunded SEC; it was the product of unethical investment banksters packaging subprime loans and credit default swaps into bogus mortgage securities, CDOs, and synthetic CDOs; it was the fault of corrupt bond ratings agencies, foremost among them, Standard and Poor’s and Moody’s.

I would nominate the ratings agencies as the primary culprit. It was they who sprinkled holy water on dogshit and turned it into fool’s gold, the better to rip off first-time home buyers, teachers, little old ladies, and international pension funds. You know―people whom the Tea Party blames for the whole freakin’ mess.

Origin of the Tea Party

I nominate  Rick Santelli, CNBC‘s resident blowhard bond maven, as the founding father of the Tea Party movement. During a television broadcast in February 2009 (that I happened to view live at the time), Santelli delivered an apparently unscripted rant in which he blamed first time home buyers for the 2008 collapse, instead of the Wall Street banksters who so assiduously recruited them to keep their mortgage bond scam going. (Go to minute 2:18 of the clip below to see his call for another Boston tea party, to the cheers of his fellow bond traders.)

CNBC’s Rick Santelli calling for the creation of a modern day Tea Party

Blaming the victim is a stock in trade tactic of the Powers That Be, and can be considered a form of institutional projection. Why the Tea Party and others are willing to blame the victims rather than the perpetrators is a question perhaps best explained by Thomas Frank and his classic book What’s the Matter with Kansas? I can’t help but wonder whether the vehement victim bashing so characteristic of right wingers doesn’t reinforce their own sense of victimhood. If the “takers,” Mitt Romney’s 47%, are the hammer, and they the anvil, the one in their eyes weilding the hammer is, of course, President Obama. Without his critical role in preventing another Great Depression, they would have really become victims of the first order. (Or as me wooden-spoon-wielding Irish granny would have said: “Stop your bellyaching, or I’ll really give you something to cry about!”)

Regulating the Regulators

Leave it to a turn of the of the millennium Roman satirist, Juvenal, to ask the essential question:

Quis custodiet ipsos custodes?  Who will guard the guards themselves?

Take the Securities Exchange Commission. (Please!) Incapable of exercising its watchdog role because of persistent efforts by congressional Republicans to underfund it and stock it with past and future industry hacks  (tactics they employ to hamstring other regulatory agencies like the IRS), there exists a well lubricated revolving door for underpaid government employees to bolt an agency for lucrative jobs in the very companies they are charged to regulate. This unfortunately legal but morally reprehensible practice is captured in a scene in The Big Short in which an SEC employee is sunning herself at a Las Vegas hotel-casino  pool on her own dime, shopping herself to potential employers. (They are all in Vegas for the annual American Securitization Forum convention,  the one that Steve Carell and his partners attended at the behest of Ryan Gosling‘s character, described briefly in the previous chapter.)

The perennial complaint of the Wall Street Republican Ruling Class, and therefore the top issue of every GOP congressional and presidential wannabe, is that there is too much regulation―corporate, environmental, and especially, financial. Even President Bill Clinton bought into that latter steaming pile of horseshit when he signed the Gramm-Leach-Bliley Ac in 1999 that repealed essential parts of the Glass-Steagall Act of 1933put into place to prevent Wall Street banksters from spawning another Great Depression. Clinton also signed into law the Commodity Futures Modernization Act, which exempted credit-default swaps from regulation, laying the groundwork for the subprime loan fiasco that followed. Whether he knew it at the time or not, Bill Clinton proved to be a classic Wall Street tool. (Hullo Hillary―care to distinguish yourself from your hubbie’s brilliant policy choices? During the next debate, perhaps?)

Half a millennium earlier, none other than Leonardo da Vinci observed:

He who does not punish evil commands it to be done.

We are all on trial here, on this World of the Cross. So, belly up to the bar―no, not that bar, silly―the bar of justice, cosmic justice. As The Urantia Book puts it:

Mercy may be lavish, but justice is precise…For mercy is not to be thrust upon those who despise it; mercy is not a gift to be trampled under foot by the persistent rebels of time.

In the final chapter, we provide an overview of the current world economy and ask the question: Are we wiser now, having experienced the worst financial collapse since the Great Depression. Or are the cognitive filters that produced the 2008 crash still in place, leaving us blind to the next catastrophe.


*I thought I was really stretching it by using this photo of B.F. Skinner to make a point about behavioral economics, but then I came across a paper by Battalio, Green, and Kagel (1981, p 621), in which they write:

[Studies of economic behavior in non-human animals] provide a laboratory for identifying, testing, and better understanding general laws of economic behavior. Use of this laboratory is predicated on the fact that behavior as well as structure vary continuously across species, and that principles of economic behavior would be unique among behavioral principles if they did not apply, with some variation, of course, to the behavior of nonhumans. [cited in Behavioral Economics]

**Another way of describing trickle-down economics, the economic theory so dear to Republicans and Wall Street banksters that holds that tax breaks for the rich benefit the middle-class, is this:

The way to feed rabbits is to feed hay to horses.



Prove you're human: leave a comment.