Translator: Michele Gianella Reviewer: Federico MINELLE
I'd like to talk about the future, about the future of economic science,
a subject that, I believe, despite everything,
can help us live in a better world.
However, to talk about the future we need to think about present time.
The present is an economic crisis without many precedents,
which has questioned
not only the international financial system,
but also many of the theories the system was based on.
If we want to pick a positive effect of the crisis
and we want to see it as an opportunity to learn something,
we can look at it
as an open-air experiment, however a dramatic one.
A large-scale experiment,
which shows us
that many economic models
tend to look like castles in the air,
they are shifting more and more away from reality.
Somebody even compared them to mental diseases,
as a defining characteristic of this kind of disease
is a progressive detachment from the world around us.
So the question is: how can we try
to bring these castles in the air a little closer to the real world
and to get an economy which helps us
and proves to be effective in solving our problems?
The question was posed by the Science magazine,
which usually deals with more important things,
but not in the midst of an economic crisis.
Science headlined an in-depth article
as “Crazy Money”.
It started as follows:
"If humans aren't rational, as the recent crisis shows,
why should financial theories assume they are?"
I'll say it again:
"If human beings aren't rational, why do economic theories assume they are?"
Even the Pope generally has far loftier issues to see to,
but he too could not refrain from commenting on the crisis,
and talking to his devoted fellows said,
"Trust in God,
not in the predictions of fortune-tellers
or.. or.. or..
economists."
It sounded like a joke to me,
and knowing what he’s like, it maybe was an unintentional one,
but he is telling us how economists' predictions
are now deemed on a par with the forecasts of a quack.
Keynes on a par with a quack.
Economic science on the same level as horoscopes.
But recently, economics isn't enjoying much favour
even among economists.
I don't know if you recognise Paul Krugman,
Nobel Prize winner for Economics and a New York Times caustic writer,
who said:
"This economic crisis was the time, for us academic scribblers,
to show why we exist.
The time to justify our existence.
The result?
A total failure, the darkness, the Middle Ages of macroeconomics."
"For us academic scribblers" -
The person portrayed there is Jean-Claude Trichet,
who for years served as president of the European Central Bank.
He isn't exactly an “academic scribbler”:
he used to hold the reins of the international monetary policy.
This summer, in an interview, he claimed,
"We, as economists,
doing economic policies in times of crisis,
we felt abandoned by conventional tools.
Economics, economic science,
should draw inspiration from other disciplines,
from psychology and from biology,
to try to explain what happened."
Well, then let's draw inspiration from psychology and from biology
and ask ourselves, "How we can develop a better theory?".
Or let’s ask ourselves, "What did not work?"
Well, typically, the subject of economic models
has all the features of Mr Spock.
If you remember the TV series Star Trek,
you will also remember that Mr Spock is totally non-affective,
he feels no emotions whatsoever,
he can work out very quickly the costs and benefits,
he knows and calculates everything.
Now a question: how many people, in this room, have pointy ears?
To what extent does this description
mirror what we are like in the flesh and blood?
Wouldn't it be better to design new economic models
inspired by Charlie Brown?
What is Charlie Brown feature?
Charlie Brown is too sweet for words.
When he sees the red-haired girl
he is madly in love with,
words fail to him, and in despair says to himself,
"My head is hot and dumb!"
When it comes to make decisions,
form judgements and to pick choices,
the head of many of us is as hot and dumb.
You know what’s interesting?
There’s a method behind our dumbness.
There's a logic behind our irrationality:
irrationality is not happening by chance.
This is what 30 years of research into cognitive sciences teach us.
They show, the box between our ears we carry around daily,
and which someone has compared to a computer,
isn't such a powerful or fast computer after all.
It has little memory, and not that reliable.
Even worse, it is prey to more bugs than we are willing to admit.
If you don't believe me, take a look here:
what are these lines like? Perfectly parallel, right?
And what are they like now? Have they curved?
What's happening? Parallel or curved?
Why is this experiment so nice?
Because in a few seconds
you have forgotten what you have just learned.
The eye sees what it sees, two curved lines,
even if you know what you know,
even if you know these lines are parallel.
We cannot think differently than the way we think,
just as we cannot see any differently from the way we see.
We activate automatic processes,
a sort of default option of our brains
and we cannot work in any other way.
Similar phenomena also occur
when it comes to decision-making and to our choices.
Now, do you agree that if you prefer A and B,
regardless of how I frame your choices,
you will always prefer A and B?
Basically, the picture shouldn't be modified by its frame.
If I am thirsty, as I am now, it makes no difference
if I take a glass that is half full or half empty.
(Drinks)
If I go shopping in Como,
what difference does it make if in a shop window
I see a sweater that's 80% pure cashmere,
compared to one that's 20% wool blend?
80% cashmere, 20% wool blend.
It is the same sweater: I'm just describing it differently.
Also, if you are on a diet,
a five percent light yoghurt and a 95 percent fat one:
five percent light is far better.
Who gives a damn about the yoghurt and the sweater,
but what if we talk about lung cancer?
This is a very famous experiment
published in the New England Journal of Medicine,
when a group of persons,
patients, physicians and medical students,
were asked what they would prefer
if unfortunately diagnosed with lung cancer?
They were asked: "Imagine that, if you choose surgery,
you'll have a 80 percent chance of survival after one year,
a 70 percent chance after two years, etc. "
And then the same probabilities were given for radiation therapy.
However, another group of people
were given the probabilities
framed not in terms of benefits, of survival -
an 80 percent chance of being alive -
but the exact same thing in terms of loss -
a 20 percent chance of dying, of not making it.
Do you agree that is exactly the same problem?
But look at what happens to our preferences:
when the choice was framed in terms of benefits,
82 percent of respondents chose surgery,
but this figure fell to 56 percent
when framed in terms of a 20 percent chance of dying.
So, it's not right to say that we have a defined system of preferences:
preferences may depend, in a totally irrational fashion,
on how options are framed.
And the difference between 56 and 82
is 26 percent,
which is the measure of our systematic irrationality.
Now, let's take a look at what happens inside our brains,
at what happens when we face cognitive tasks like these.
We can do so with a technology called Functional Magnetic Resonance Imaging,
from which we can infer what areas are activated inside our brains
by looking at the haemoglobin signal, which is captured by Brain Imaging.
And what do we discover?
We discover that people
who are very sensitive to the framing effect,
so who are irrational in this specific respect,
respond with their amygdala, that is with the part of our limbic system
which we share with reptiles and mammals.
What does it respond to? To fear.
And it is our emotional memory of fear
that activates the flight-or-fight response!
And those who behave more like Mr Spock?
They respond with that part of our brain
that sets us apart from reptiles and other mammals,
the prefrontal cortex:
the greater the activation of the prefrontal cortex,
the greater the rationality index.
This experiment also teaches us another very interesting thing:
that Mr Spock doesn't exist,
because in nobody,
not even in those who answer correctly when given choices like these,
there is a simple activation of the prefrontal cortex.
An emotional response is triggered in everyone.
So, being more rational doesn't mean not feeling emotions,
but more rational people have a better meta-representation
of their own emotions, of their own cognitive processes.
More rational people act with a better self-understanding,
their emotional conditioning and their mental mechanisms.
So, let's put ourselves to the test with a financial decision,
an economic decision.
Just imagine you are playing with me:
I’ll toss a coin, 50 percent heads, 50 percent tails.
If it's heads, you win €100; if it's tails you win nothing.
Who’s going to play with me, 50 percent odds of winning or losing €100?
Very few, it seems.
Who’s willing to play with me, the odds being 150 against 100?
Now you win 150, but you risk losing only 100.
A little more interesting, isn't it?
Who bets on a 50 chance of winning 200
against a loss of only 100?
Even more interesting?
250 against 100: who is going to play?
Oh, come on!
300 against 100. 400 against 100, 500 - okay.
So, what most people do,
all around the world?
They accept a bet like this when they can win €225
and lose just €100:
it means that the losses hurt twice as much
than the pleasure of a winning.
For our brain
losses and benefits don't add algebraically.
I don't feel the same
if I earn 100 then lose 100 and have zero.
In the psyco-economy of Charlie Brown,
losses weigh twice as much as wins.
There is at Yale University a family of Capuchin monkeys
who have been taught to use money.
Capuchin monkeys learn quite quickly how to use cash
and they quickly learn the law of supply and demand.
They grasp economic rules,
but are victims to our same bugs.
Monkeys, just like humans have an aversion to losses
and in exactly the same ratio: 2.25 to 1.
What does this tell us?
It tells us that having an aversion to losses,
being afraid to lose money,
it is something that's sort of written in our genes,
something that dates back to at least 40 million years ago,
before we separated from our ancestors.
There's more to it:
if we think about it, it all does makes sense,
as having a tool that is extremely sensitive to losses
is what probably brought us so far.
In evolutionary terms, fear acts like an alarm system:
being afraid of losing food, of losing shelter,
of being attacked by a predator
is what probably grant our survival.
Bear in mind that people
who have a specific selective, focal lesion of the amygdala
have no fear of losing.
They are typically people who,
in a bet like the one we have seen before,
if they play many times, even if they initially lose,
will keep on playing;
and rightly so
as they stand greater chances of winning than of losing.
So, what's the first lesson to be drawn?
The first lesson is that
if you want to comply the rulebook of the perfect economist,
being brain-damaged will help.
(Laughter)
What's the second lesson?
It is that trying to beat the market…
We are provided with an alarm system
and our brain is made to survive in the savannah,
that's how it did evolve:
trying to beat the market and make money on the stock market
using the amygdala and your dopaminergic neurons
is unwise, to say the very least,
After all, if seen in the perspective of the whole history of evolution,
Wall Street and Piazza Affari are quite recent phenomena.
We haven’t necessarily evolved enough
to survive the ups and downs of the stock market.
The third lesson is that you must be very careful.
It's a cliché,
but you all know that the seasons are no longer what they used to be.
This is true for predators as well.
[Cayman]
(Laughter)
What should we do?
What does this neurobiology of rationality teach us?
What does this neuroanatomy of errors teach us?
How can we make economic models more realistic
in order to develop more effective theories?
Well, denying the importance of psychology,
of cognitive sciences and of neuroscience
in economics
would be like ignoring friction forces in Newtonian mechanics.
I’m sure you understand
that if you want to apply Newtonian mechanics
to building devices that work in this world,
you have to take friction forces into account.
The same holds true for neoclassic economics.
If you want to have models that work in the real world,
and that make it work better,
you can't ignore friction forces.
So, what are in this case the friction forces?
They are the friction forces of human irrationality.
In short, the question is: is it possible to learn to take better decisions?
Is it possible to learn to be a little more rational?
Is it possible to develop better economic theories?
Is it possible to design better economic institutions
for the world we live in?
Can we? Yes, we can.
Or, Yes, we can!
How?
This is my provocative proposal:
banks, governments, central banks and financial institutions
should provide themselves with an ETF.
What is an ETF? An Emotional Task Force.
And what about us? What can we do?
Well, for us it is easier:
all we have to do is studying less neoclassic economics
and read the Peanuts more often.
Thank you.
(Applause)