The biases that limit our thinking about the economic outlook and policy.
Business Economics (2012) 47, 297-301.
Keywords: bias, economic outlook, economic policy, markets, regulation
Effective economic policy--and important private economic decisions--begins with a thoughtful review of five facets of the economy--growth, inflation, interest rates, the dollar, and corporate profits. The purpose of this essay is to identify the biases that limit our perceived available choices and then relate these biases to the choices and to other aspects of economic policy making and private-sector decisions.'
1. The Sunk Cost Bias: Recessions Come, but Also Go
In the current recovery, the pace of growth is subpar compared with prior economic recoveries. This brings us to our first policy problem and the first bias that limits our perceived available choices. In his book, Into Thin Air, Jon Krakauer  offers us an example of mountain climbers who seek to reach the top of Mount Everest. After a considerable expense of training, equipment, and time, the climbers reached the last camp before the approach to the summit. However, the approach to the summit was more difficult than anticipated, and a number of climbers who started the final ascent after the recommended last departure time subsequently died.
This real-world example brings up the problem of the sunk cost bias--the tendency to escalate commitment to a course of action while ignoring the mounting costs of the action relative to the anticipated benefit. In military terms, this is the story of many of the battles of the Somme, Ypres, and Verdun in World War I.
In economic policy today, the challenge is for us to judge whether another fiscal stimulus program, another quantitative easing, another housing program, or another financial regulation would be just enough to reach the top of the mountain, for example full employment, reestablish the strength of housing a la 2005-07 or greater financial stability than what we have achieved so far. Or could further policy moves be too much? Would we be violating some sort of economic rules or balancing act in the economy where the continued pursuit of these policies be counterproductive, such as bringing on too much federal debt that could not be repaid over time--a mini Greece perhaps? The basic question is whether the marginal cost of expanded policy actions would outweigh the marginal benefits of such actions--not how much has been done already. Of course, for the private sector, this is drummed into economists in their first encounter with the theory of the firm.
2. The Overconfidence Bias
Within the economic growth debate, we also face a second bias in our decision-making on policy choices. In the economic recovery of the 1960s, the belief was that the economic problems of the business cycle were solved and that adjustments in fiscal policy could be made to correct any economic deviation from the desired trend. In 1967, with rising inflation and rapid economic growth and the costs of the Vietnam War escalating, Congress voted in 1968 to pursue a temporary tax surcharge to fine-tune the pace of economic growth and reduce inflation. It failed on both counts and illustrates a second bias in our decision-making: the overconfidence bias, or the belief that our approach to any issue will succeed even though we may not have tested this approach before or applied it in a particular way. Think here, in military terms, of the invasions of Russia by Napoleon and Hitler.
In economic policy, this is the story behind many temporary fiscal stimulus programs and rebates, the cash-for-clunkers program, and the first-time homebuyer credit. The structure of the U.S. economy has changed significantly from the fiscal successes of the 1960s and 1980s. Economic agents are considered to be more rational in the sense that they model the economy and thereby assess the implications of policy actions--particularly temporary policies. Moreover, any impact of these temporary fiscal programs may be limited by more fundamental problems of the labor, housing and credit markets in the United States. For example, we have seen that policymakers' estimates of the impact of these programs on growth and employment were over-optimistic in the short run and much less effective than expected over time. In this case, policymakers were overconfident. In assessing government policies on private firms, it is necessary for them to make their own assessment of whether a government policy will have its expected effect, and detection of possible overconfidence bias should be an important part of that assessment.
Going forward, any policy actions taken to increase the pace of economic growth must be scrutinized in the context of an economic framework (rational agents, globalization, a changed credit/financial landscape) that is quite different from that assumed by policymakers when they base their models on the decades of the 1960s and 1980s. Stated more dramatically, going after a shark with a standard boat can be a mistake; as Martin Brody, the police chief in Jaws said, "you're going to need a bigger boat."
3. Has the World Really Changed? The Recency Bias
Current inflation expectations reflect the belief that inflation should be moderate in 2012, as commodity and producer price inflation slows and unit labor costs remain tame. Policymakers refer to the persistent low, stable, inflation expectations in the marketplace as confirmation that the current policy is appropriate and will be sustained for several years. In this context, the high consumer inflation of the 1970s appears to be an aberration and inflation appears to have settled into a range between 2 and 3 percent.
The recency bias is a tendency for decision-makers to overweight recent experience--"this time is different"--even if the underlying model of inflation has not truly changed. For many investors, the recency bias reflects the tendency to rely on the last piece of information reviewed as the crucial data point for the foundation for a decision. Thus, the question raised on the inflation outlook is: Is the pace of inflation in the future independent of the large increase in the Federal Reserve's balance sheet? Is this time really different? The question before the Federal Reserve and investors is: Will the recent rise in the Federal Reserve's balance sheet truly be independent of any rise of inflation in the years ahead?
4. The Illusory Correlation Bias
The illusory correlation bias occurs when two economic series appear to have an extremely tight statistical relationship when there is little or no theoretical link between the two variables. Historically, this bias is represented by the sunspot theory of the modern business cycle, but many of us are very familiar with the many supposed relations between gold or oil prices to anything else that moves in the economic universe. In another economic context, the Communist approach to economic policy grew in popularity during the 1920s when Russia appeared to sail through the decade without experiencing the Great Depression taking place in Western Europe and the United States. The appearance of success was an illusion, but reality only became obvious with the passage of time.
For inflation, the issue is the apparent lack of a correlation between money growth and inflation, where plausible theory suggests the opposite. In this case, belief that lack of correlation will persist implies the belief that inflation will not be a problem ahead, even with monetary growth--despite plausible reasons to believe the contrary.
5. The Normalization of Deviance Bias
During the Challenger space shuttle launches of the 1980s, deviations from the normal, desired behavior in the 0-rings of the shuttle were observed, but since no significant problem resulted, these deviations were considered anomalies and did not halt program launches. Over time, these anomalies became the accepted course, and thereby interpreted as part of the normal course of affairs--until the launch in 1986 when these deviations did matter, causing catastrophic results. The bias we need to address here is the normalization of deviance problem, which was the problem of the last decade and the underlying driver of the Greek debt problem today.
Is this the same bias we face in our thinking today? In recent years, the perception has grown that increases in the federal deficit and projected future deficits have no relationship to current interest rates. This implies that there is a "free lunch," as increased deficits appear costless in terms of their effect on interest rates. The current consensus outlook is for continued low interest rates for several years ahead.
In recent years, the deviation of the federal budget outlook from previously accepted standards has increased dramatically. In prior decades, policy estimated that at some time in the near future--usually ten years--the budget would be brought into balance. The estimates were for federal fiscal deficits, in the out-years, to range from 2 to 4 percent of gross domestic product. Now the estimates are for deficits that range from 6 to 8 percent of gross domestic product. Contrary to prior administration budget projections, there is no longer the fiction that the budget will be balanced sometime in the future. Instead the best that we can do is 5 percent deficits as a share of GDP--assuming interest rates stay low for the same foreseeable future. We are on a slippery slope of policy made easier by the normalization of deviance bias. All of this could come to grief quickly if interest rates start to rise faster than many estimate.
For both private and public decision-makers, is this deficit deviance a warning sign of problems ahead or simply something that will become the standard fare in the future, without any negative complications? In the past decade, mortgage lending standards increasingly deviated on the easy side relative to earlier years. Reduced down payments and lower FICO credit scores became the standard on our way to a housing bust. Is this normalization of deviance bias becoming ingrained in U.S. fiscal policy? If so, what are the consequences, and how can firms protect themselves?
6. The Confirmation Bias
We are already familiar with the confirmation bias in practice, if not in name, in both the financial markets and in the political arena. In financial markets, many strategists who are perma-bulls or perma-bears will always find the one nugget of information that will support their case. In politics, the reliable Democrat or Republican strategist can be called upon to pull out at least one poll to support their case. In fact, many recent political commentaries about political debates primarily revolve around polls rather than fundamental differences in policy.
In economics, jobs are the number one concern in the economy in this election year; and the recent improvement in the job situation hints that job gains are sustainable over time. However, the pattern of public response to the announced job gains reflects another bias in our thinking that has haunted decision-makers before--as recently as in the last two years. Remember the "summer of recovery"? The confirmation bias refers to the tendency of analysts to interpret economic information in a way that confirms beliefs based on prior experience rather than objectively looking at the information on hand. In other words, we see what we want to see. (2)
In recent months, the job market has improved, as initially indicated by the decline in initial jobless claims, yet these economic signals fall short of the full story. The cyclical improvement in the jobs picture obscures the real structural problems in the labor market, in which unemployment in excess of 8 percent persists. We can also observe that the employment-to-population ratio remains far below pre-recession levels and has not improved in recent months. This persistence again implies that structural unemployment remains a major issue. The focus on the decline in the unemployment rate suggests a confirmation bias for many analysts who see the unemployment rate decline as a signal of improvement. Meanwhile the skeptics will focus on other signals, such as high long-term unemployment as signal of continued problems.
7. The Anchoring Bias
In real estate and in autos, the listing price or the suggested retail price sets the initial bar for value and the bargaining starting point between buyer and seller. When bargaining between buyer and seller begins with an initial reference point such as the listing price, the process is said to have an anchoring bias as the anchor tends to provide an arbitrary basis for all subsequent negotiation.
This anchoring bias affects the housing debate in three ways. First, the price of houses that buyers grossly overpaid for in 2006 or 2007 is still perceived as the real value of the homes by these buyers. Second, credit was widespread during the last housing cycle and buyers have difficulty understanding why standards are so much higher today. The common concern is that credit is simply not available---that is, unavailable at the old anchored standard. Finally, for the nation as a whole, the expectation is that housing starts "ought to be back at the high levels of the past decade while the fundamentals in the economy no longer support such a level.
In contrast, the real U.S. post-WWII economy has constantly evolved so that the sustainable pace of home prices, mortgage credit and housing starts will always change over time. There is no real anchor. Yet policymakers and private market participants set their expectations based upon a perceived anchored value set in the past. In a similar way, we see the same pattern for the overall pace of expected economic growth and full employment. Instead, there is always a "new normal"--each recession and recovery is unique and old standards remain old but no longer standards. (3)
Anchoring also complicates the actual conduct of fiscal and monetary policy, as policymakers attempt to reestablish the old anchors of perceived rates of economic growth or interest rates and thereby create distortions in the financial markets for the dollar, interest rates, inflation, and credit allocation. For example, monetary policy directed toward reestablishing the anchor benchmark for housing starts will stay too easy for too long and thereby distort capital market interest rates.
What is normal for housing depends on interest rates, credit standards, income growth and the demographics of a society; and all these factors evolve over time. A problem arises when policymakers establish an arbitrary anchor based on an historical benchmark to guide policy that may be totally inconsistent with the current fundamentals of the economy. When central banks misprice interest rates, it is not surprising that the financial system will misprice credit.
8. Framing Bias and Financial Market Regulation
Framing bias occurs when the way a decision is presented (framed) influences the outcome. Every decision we make carries with it both risk and opportunity. Yet, when the issue turns to financial markets, the frame of regulators is entirely on avoiding risk--with little reflection that many opportunities will be lost. For some financial market participants, the frame of opportunity is everything, and there might as well be no risks. Framing bias often influences much of private and public economic behavior.
Debates on the privatization of Social Security, for example, turn on the perception that investments within the program would be risky. In contrast, U.S. Treasury debt is often termed "riskfree," when in fact U.S. Treasury debt is risky in the sense that changes in inflation, the dollar, or interest rates significantly alter the market value of that debt. U.S. Treasury debt may be default-risk free, but even this may only be temporary, given the rapid growth of federal debt in recent years. Framing is also prevalent in other areas of public policy, such as the risk takinglrisk avoidance biases in decisions to drill or not drill for oil or natural gas when fracking is involved.
In considering the economic outlook and the development of private decisions and public policy, we must assess the economic fundamentals on both a cyclical and structural basis and we must recognize that, while the economy is recovering on a cyclical basis, the hard realities of structural changes for labor, housing, and the federal deficit remain to be addressed. In economics, as in biology, it is not the strongest of the species who survives but the one most adaptable to change.
Effective economic decision-making that addresses these structural barriers requires that decision-makers make a thoughtful self-examination into the biases that may limit perceived available private and public economic choices, as well as being wary of the biases of others. (4)
Thanks to Sarah Watt, Tim Quinlan and Sam Bullard for their help in this essay.
* Adapted from a speech given to the Union League Club in New York City on March 5, 2012.
Ambrose, Stephen. 2000. Nothing Like It in the World. Simon & Schuster.
Goodwin, Doris Kearns. 2005. Team of Rivals. Simon & Schuster.
Gordon, John Steele. 2001. The Business of America. Walker Publishing.
Krakauer, Jon. 1997. Into Thin Air. Anchor Books.
Kuhn, Thomas. 1962. The Structure of Scientific Revolutions. University of Chicago Press.
Neustadt, Richard E., and Ernest R. May. 1986. Thinking in Time. The Free Press.
Silvia, John E. 2011. Dynamic Economic Decision Making. Wiley.
(1.) For a great read on making and remaking choices in a business context, see Ambrose . in a political context, the choices of Abraham Lincoln are essential reading [Goodwin 2005].
(2.) See Neustadt and May . The authors provide an excellent review of many examples, including the Cuban Missile Crisis and the Vietnam War, in which decision-makers reasoned from a false set of prior beliefs about how the world works.
(3.) For a thoughtful discussion of the evolution of economic and scientific change, see Kuhn . For examples applied to business and economics, see Gordon .
(4.) For a more complete review of many of these issues, see Silvia .
JOHN E. SILVIA *
* John E. Silvia is the Chief Economist of Wells Fargo Bank and a Past President of NABE.
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|Comment:||The biases that limit our thinking about the economic outlook and policy.(Forum on Emerging Issues)|
|Author:||Silvia, John E.|
|Date:||Oct 1, 2012|
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