It’s not easily recalled now, but in June 2008 the big news story in the United States was not terrorism, war, or economic crisis. It was tomatoes. Killer tomatoes. Or to be more precise, potentially killer tomatoes.
An outbreak of salmonella food poisoning that started in April had spread across most of the U.S. by June, and hundreds of people had taken sick. Tainted tomatoes were suspected. Salmonella can kill, even if it hadn’t in this outbreak, so it was a serious concern. Whether it was as serious as journalists and the public believed it to be is another matter.
The media were flooded with stories about the outbreak, and food safety in general, and the public paid close attention. In a survey conducted by the Pew Research Center for the People & the Press, 66 per cent of Americans said they had heard “a lot” about the salmonella out break while another 28 per cent said they had heard “a little.” A mere 6 per cent said they had heard nothing. Those are impressive numbers. By comparison, only 34 per cent of Americans said they had heard “a lot” about an ominously steep drop in car sales announced by Ford and General Motors.
As it turns out, tomatoes were unjustly accused. In July, the culprit was discovered to be Mexican jalapenos. The outbreak ceased. The Killer Tomato Scare of 2008 was soon forgotten.
There was another risk-related story in June 2008, but this one hasn’t been forgotten because it was never noticed in the first place.
“U.S. Deaths Down Sharply in 2006” reads the June 11 press release announcing the latest statistics from the Centers for Disease Control. “The 2006 age-adjusted death rate fell to 776.4 deaths per 100,000 population from 799 deaths per 100,000 in 2005,” the release says. “In addition, death rates for eight of the 10 leading causes of death in the United States all dropped significantly in 2006.”
Influenza and pneumonia deaths – down 13 per cent. Stroke deaths – down 6 per cent. Heart disease deaths – down 6 per cent. Diabetes deaths – down 5 per cent. aids deaths – down 5 per cent. Cancer deaths – down 2 per cent. Even infant mortality was down 3 per cent. In a single year. This was important and wonderful news.
And yet, a scan of the media finds the cdc’s good news was essentially ignored by television broadcasters, while newspapers relegated it to a paragraph or two on page a15. It was what we in the trade call filler. Of course, the cdc didn’t help matters by writing a press release with all the colour and excitement of an accountant’s spreadsheet, but that isn’t why this story got so little notice. It was overlooked for reasons found in this book – the same reasons that explain why the relatively minor story of the (potentially) killer tomatoes became such a sensation.
It is inevitable that a book based largely on current events, as this one is, will be overtaken by events to some extent. The best one can hope is that the book illuminates, and is confirmed by, what happens after the final manuscript is handed over. That’s certainly what happened with the two big risk stories of June 2008. In fact, I couldn’t have asked for a better illustration of what the book is all about.
But the next big risk story – the story that became the monster of 2008 – is something else entirely.
Early on in the writing of this book, I decided there would be nothing about financial risks, only those risks that can sicken, injure, and kill. It’s about hits to the head, I told friends, not to the bank account. This was an arbitrary decision, made in order to keep the book from bloating. It had nothing to do with the subject matter. The brain we use to grapple with financial risks is the same brain we use to decide which threats to life and limb are worth worrying about and which we should ignore. The psychology is the same. So is the critical role of the media in our decisions. And it goes without saying that there are plenty of individuals and organizations whose self-interest lies in manipulating the decisions of home buyers, consumers, and investors. From the perspective of risk perception, a risk is a risk, whether it’s your skull or your retirement savings that will suffer if you make a mistake.
That decision turned out to be as unfortunate as it was arbitrary because, of course, the great risk-related story of 2008 was all about dollars and cents. The bursting of the U.S. housing bubble was followed by a credit crunch on Wall Street. Pillars of international finance wobbled and fell. Stock markets plummeted worldwide. Every economic indicator turned red, and now, at the time of writing in late 2008, we are mired in an economic crisis that has, in all likelihood, only just begun. And it all started with risk perception.
There are many places and moments we could look at to try to understand what went so catastrophically wrong. One place is San Francisco. One moment is 2005.
Home values were soaring, as they had been for years, in San Francisco and across much of the United States. So economists Robert Shiller and Karl Case decided to survey new home buyers in San Francisco and ask them a question that was on the minds of everyone buying property that year: Will home values continue to rise? If so, by how much?
Laypeople may not explicitly think of these sorts of financial questions as decisions about risk, but that’s what they are. Always, in money matters, there is the prospect of gain or loss. Stuff your money under the mattress and you may avoid losing your savings in the collapse of a bank – that’s a gain – but you may instead miss out on the interest earned by putting it in the bank. That’s a loss. Or your house may go up in flames, along with your mattress and your cash. That’s a big loss. There’s no escaping it: Every financial decision is a decision about risk.
Those who decided to buy a home in San Francisco in 2005 didn’t see much risk in it. What they saw was profit. The homebuyers surveyed by Shiller and Case not only expected home values to continue rising, they expected them to soar: The average expected increase was 14 per cent a year for a decade. “About a third of the respondents reported truly extravagant expectations,” Shiller recounts in his book The Subprime Solution. Some actually anticipated increases of over 50 per cent a year.
It didn’t quite turn out that way. Not long after Shiller and Case conducted their survey, the dizzying rise of American home values stopped, and then, like a rocket that’s run out of fuel, prices turned and started falling back to earth. This reversal sparked the credit crisis. The credit crisis shook the stock markets. Then things got really bad. This sequence is important to bear in mind. Although many factors lay behind the economic crisis that got rolling in 2008, it simply would not have happened without the spectacular rise and catastrophic fall in American home values.
Ask most economists about what went wrong with home values and they’ll talk about interest rates, sub-prime loans, predatory lending, derivatives and credit swaps, leverage, incentives, and regulations. This is the stuff of conventional economics. It is also the stuff of conventional media coverage and conventional public policies.
But there are dissident economists who think the conventional explanation, although valid in many ways, misses the core component. Robert Shiller is one of them. “The ultimate cause of the global financial crisis,” he writes, “is the psychology of the real estate bubble.”
More than his impressive title – the “Arthur M. Okin Professor of Economics at Yale University” – Robert Shiller’s credibility rests on being right when so many others were wrong. In March 2000, at precisely the moment that Standard and Poor’s 500 Index hit what would turn out to be the peak of the tech bubble, Shiller published a book – Irrational Exuberance – that argued there was no good reason why stocks had soared. It was a speculative bubble, he wrote, a bubble every bit as irrational and unsustainable as the very first such bubble, the Dutch tulip mania of 1637. Most analysts scoffed. The markets were headed nowhere but up, they said. (Dow 36,000!) Then the bubble burst. Shiller’s book became a best-seller.
In a revised edition of Irrational Exuberance, released in 2005, Shiller blew the whistle on real estate. It’s another bubble, he insisted. Once again, he was widely dismissed, and once again he was proven right in catastrophic fashion.
How did Shiller do it? Nothing fancy. Mostly, he looked at basic facts. A chart of the price–earnings ratio of American stocks since the 19th century showed a line rising rapidly from 1982 to 1996 and then – even though it was already far higher than the historical norm – taking off like a rocket. It wasn’t hard to see this was out-of-control speculation that had very little to do with economic fundamentals. The hard part was not seeing it.
The same was true of the housing bubble. A chart of American home values from the late 19th century onward showed that, with the exception of a collapse during the Great Depression, they sometimes bobbled up and down but mostly stayed flat until the end of the 1990s. Then they went near-vertical. Lines charting interest rates, building costs, and population growth gave not the slightest explanation for this unprecedented explosion.
In hindsight, these bubbles are embarrassingly obvious. So why, at the time, did so few people see them for what they were?
Conventional economics struggles to answer that question because, as I noted in chapter three, it views humans not as Homo sapiens but as Homo economicus. This “economic man” is consistently rational. When making decisions, he observes facts and calculates options. He then chooses whichever course of action best advances his self-interest. What Homo economicus does not do is buy a house at a grossly inflated price and expect its value to keep rising rapidly.
Conventional economics is also fond of a related idea called “efficient markets theory.” This is the notion that markets take all publicly available information into account at all times and so prices are always reasonable and correct. Sometimes prices may look out of line. But that’s an illusion. The market is never wrong. Needless to say, the bursting of the housing bubble and subsequent disaster left “efficient markets theory” wobbling like a drunk on a one-legged stool.
It was all too much for conventional economists, including Alan Greenspan, the renowned former chairman of the U.S. Federal Reserve System. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself especially, are in a state of shocked disbelief,” Greenspan told a Congressional committee in October 2008. Banks aren’t run by fools, Greenspan had always believed. They would never lend large amounts of money to large numbers of homebuyers who might be unable to pay it back. And if they did do something so foolish, the sophisticated players of the financial markets would never pay good money for such bad debt. It would be contrary to their self-interest. It would be irrational.
And yet, it happened.
The 2008 meltdown was an I-told-you-so moment for the dissidents. Along with Robert Shiller, they include Dan Ariely, the mit economist and author of Predictably Irrational, Cass Sunstein, the Harvard legal scholar and public policy expert quoted often in this book, and Richard Thaler, the University of Chicago economist. They are among the leading thinkers in the new and burgeoning field of “behavioural economics,” which seeks to bring the insights of cognitive and social psychology to economics. That effort begins by correcting a fundamental mistake conventional economics makes – a mistake with enormous consequences. “Why did Mr. Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen?” Sunstein and Thaler wrote in the Financial Times. “We think their mistake was to neglect the role of human nature.”
People are not the rational actors of conventional economic theory, the behaviouralists say. We are only “boundedly rational” – rational within limits. The fact that we are often rational is the reason why conventional economics often works; the fact that there are limits to our rationality is the reason why conventional economics occasionally falls on its face.
An important example of bounded rationality is “loss aversion.” If people were strictly rational, they would consider a gain of $100 to be the same value as a loss of $100. But they don’t. As Amos Tversky and Daniel Kahneman showed, people feel much more strongly about avoiding losses than they do about acquiring gains. So a $100 loss counts for much more in their thinking than a $100 gain.
The psychology the behaviouralists bring to economics is not, please note, the “psychology” that’s often mentioned by journalists and pundits on days when the markets plummet and Wall Street is said to be in a “panic” – as if wide-eyed traders are leaping around stock exchange floors like gazelles chased by lions. For one thing, extreme emotional states such as panic are rare even at the site of bombings and other catastrophes. In boardrooms and stock market floors, they are essentially non-existent.
More importantly, the fate of markets and economies is not decided on the extraordinary days when stocks soar or collapse and everyone on Wall Street goes home exhausted. After all, the housing bubble took at least half a decade to develop, while the credit crisis played out for more than a year before Wall Street was brought to its knees.
The psychology that matters is something else entirely. It’s the psychology that led people to believe housing prices would keep going up and up and it was therefore a good idea to take on new and bigger mortgages and spend home equity on vacations and giant-screen televisions. It’s the psychology that led banks to offer mortgages at ever easier terms to people who couldn’t possibly repay the money if home values stopped inflating. It’s the psychology that led financial markets to think these dangerous debts, packaged and sold as derivatives and other exotic financial instruments, were low risk – were, in fact, such a good investment that it was wise to borrow huge sums to buy them.
It shouldn’t be hard for anyone who has read this book to imagine many ways in which the Anchoring Rule, the Rule of Typical Things, and the other cognitive mechanisms of the unconscious mind might have influenced the thought processes that lay behind these conclusions. Consider the Example Rule. Why did American regulators not seriously consider the possibility that there may be a major, nation-wide decline in home prices? Such a thing had not happened since the Great Depression, they said; it’s so unlikely it’s not worth worrying about. But the run- up in prices the country was experiencing had never happened before, so simple logic would suggest this was new territory and regulatory responses should not be dictated by past experience. That’s not hard to understand. And yet, regulatory responses were dictated by past experiences – as we would expect if the Example Rule were making itself felt in the intuitive judgments of regulators. As I quoted Robert Kates complaining in chapter three, “men on flood plains appear to be very much prisoners of their experience.” Men in boardrooms, too.
At the core of the catastrophe, however, is the housing bubble, and it is best explained with the social psychology discussed in chapter six. “What started this whole thing going was a speculative bubble in which people were taking close account of the information signals of others leading to a situation in which ‘everybody knew’ that home prices always go up in the US, which actually isn’t true,” Cass Sunstein says.
The growing complexity of financial instruments – from personal mortgages to the arcane derivatives traded on financial markets – contributed to the tendency to follow the pack. “The credit markets have gotten more and more difficult to navigate in the past 20 years,” Sunstein notes, “and when you have all this fine print and confusing terms, people tend to say ‘yeah, whatever.’”
How does this mortgage work? Will I be able to pay it off? What exactly is this derivative? Is it a sound investment? For laypeople and Wall Street wizards alike, these were tough questions. They were also important questions, with serious consequences for those who answered incorrectly. And it is precisely under those conditions – as Robert Baron, Joseph Vandello, and Bethany Brunsman showed – that people are most likely to abandon their own judgment and follow the lead of others.
Many analogies are used to describe this dynamic. “Herding” is the obvious one. Another is “contagion.” Sunstein prefers to call it an “informational cascade”: The fact that many people believe something convinces more people of that thing, which settles it for still more people, and so on.
Now add the pernicious influence of confirmation bias. Then add news media reporting that not only failed to expose mistaken beliefs but accepted, repeated, and amplified them. And don’t forget the many individuals and organizations with a vested interest in how the public perceived real estate risks. In 2008, as air hissed out of the housing bubble and scales fell from eyes across America, the National Association of Realtors launched a $40 million ad campaign promoting the “fact” that, on average, home values nearly double every ten years. Technically true. And totally misleading. That figure, based on data covering the last thirty years, includes the unsustainable growth of the housing bubble. Worse, it isn’t adjusted for inflation; do that and most of the increase vanishes.
On and on the information cascade expanded, sweeping over thousands of people, millions, tens of millions. Why did so many people fail to see the real estate bubble for what it was? This is why.
If it seems incredible that a tsunami of error could wash over a society in an era when accurate information is cheap, abundant, and available at the click of a mouse, remember that information technology also makes it easier to get the opinions of others that we find so compelling. Remember also that Google and the Internet only provide what users ask of them, and given the influence of confirmation bias, what most users ask of Google and the Internet is confirmation of what they already believe.
It’s easy to fall into despair. If the economic turmoil we are experiencing is rooted in psychology, what can we do about it? Human nature can’t be changed. Is there nothing we can do to lessen our vulnerability to economic mania?
In fact, there is. Human nature may be unchangeable but much of the environment in which people live is of our own making. It can be changed. “If we want to prevent things like this from happening again, we have to create tools that are designed for humans and not Homo economicus,” says Cass Sunstein, whose book Nudge, co- written with Richard Thaler, is about how to do just that.
A good place to start is ensuring markets have better information. “We need disclosure requirements that are built for 21st century financial products,” Sunstein says. The idea isn’t to generate more information. The last thing the markets need is more information. It’s to simplify and clarify information so that regulators, managers, advisers, bankers, and brokers are less inclined to say “yeah, whatever” and follow the herd. Sunstein calls it “simplified transparency.”
The same principle holds for consumers. “The whole catastrophe started because it’s very hard to figure out how much mortgage people should take,” Dan Ariely says. Mortgage calculators weren’t much help because they are typically provided by financial institutions whose interest lies in people taking out bigger mortgages, so they don’t factor in possible setbacks – job loss, declining home values – and they don’t tell people the optimum mortgage they should take. Instead, they tell people the maximum mortgage available.
Compounding this problem is “optimism bias,” which I mentioned briefly in chapter 11. Very simply, people tend to see themselves in a good light. If they are asked about their driving skills, most will say they are “above average.” Intelligence? Above average. Looks? Above average. When it comes to risk, this bias tends to unreasonably diminish the possibility of something bad happening. So if a forty-two-year-old factory worker with a suburban bungalow in a decent neighbourhood is asked how likely it is that a forty-two- year- old factory worker will lose his job, or that a suburban bungalow in a decent neighbourhood will decline in value, he will give a certain estimate. But if he is asked how likely it is that he will lose his job, or how likely his home is to decline in value, he will give a different estimate – a lower estimate.
“We don’t think about all the things that could go wrong,” Ariely says. Because of this bias, and the difficulty people have in figuring out how much mortgage they can reasonably handle, “they borrow way, way too much.” Ariely recommends governments provide – or pay third parties to provide – easy- to- use mortgage calculators that give people advice untainted by optimism bias or the self- interest of lenders, mortgage brokers, and real estate agents. Robert Shiller goes further, calling for governments to subsidize independent, disinterested, financial advice for those who cannot afford it. If this had existed a decade ago, Shiller writes, “the crisis might never have occurred.”
Perhaps. Of course we’ll never know. The one thing we can be sure of is that things went very wrong and the crisis that started in 2008 is very serious. Interviewers have asked me whether this undermines the very hopeful message – “there’s never been a better time to be alive” – that closes my book.
The answer is no. Not in the least. It takes only a little historical perspective to see that we are the healthiest and longest- living people in the history of the species. And as people would know if the media had paid attention to those cdc statistics, we’re getting healthier and longer- living by the day. Those of us who live in the developed world, along with growing numbers in the developing world, are also the wealthiest people who ever lived: In 1900, the average American made $4,748 a year (in 1998 dollars); by 1998, that had risen to $32,444. Over the same period, the hours worked by the average full- time employee fell from 60 per week to 40, while the portion of the average family’s budget that went to food fell from 44 per cent to 15 per cent. Even if this economic crisis is severe and a decade of progress is lost, the average American – along with the average Canadian, Briton, Australian, and a lot of other ordinary people on the planet – will still enjoy material prosperity greater than anything royalty could have commanded not so long ago.
Our species has always faced threats – monetary and mortal – and always will. We can be sure that the future will see setbacks, tragedies, disasters, and catastrophes. But barring Armageddon itself – the ultimate low probability–high consequence event – we will not be knocked back so far that our time will cease to be the best time to be alive. Very simply, we will remain the luckiest people who ever lived.
“The future is unknowable,” Winston Churchill wrote in 1958, “but the past should give us hope.” If we care to look.