Boom Bust Boom: Why we must adapt economics to human nature

Monty Python‘s Terry Jones, and Theo Kocken, Professor of Risk Management at the VU University in Amsterdam, joined forces to spread the word: bubbles exist, crashes do happen, and human behaviour needs to be considered in economic policy.

Their documentary film Boom Bust Boom combines comedy and serious analysis to explain why crashes happen, and features appearances by John Cusack, journalists Paul Mason and John Cassidy and leading experts, including Andy Haldane, the Chief Economist of the Bank of England and Nobel Prize winners Daniel Kahneman, Robert J. Shiller and Paul Krugman. We spoke with Professor Theo Kocken about his film and the urgency of its message.

You say you want to adapt economics to human nature. What does that mean, and what does it say about how we currently think about economics?
Humans make decisions with their “older brains,” which are well fitted for the savannah, but not always for financial markets. We need to accept that humans are not rational robots, but tend to make decisions that do not always make proper use of the big brains we have developed over the last million years (the Neo Cortex)—rather we make decisions based more on emotions, like herding and overconfidence.

507562273_640Current economic thinking sees humans as rational robots, calculating the benefits of buying a house or stocks based on discounted cash flow analysis. The fact is we buy these assets because we see the price going up and everyone else is buying. Higher prices mean lower demand in traditional economics, but not necessarily in behavioural economics. We have experienced collective irrationality time and again in history and will continue to do so in the future.

In a nutshell, what went wrong in 2008?
Something went wrong in the 25 years prior to the crisis: the illusion got hold of people that they could all make money out of (borrowed) money and get rich easily. This lead to extreme amounts of borrowing and at the same time a huge bubble in houses and stock prices. This combination is toxic: instability grows to an unsustainable level. When the prices start to fall a bit, a domino effect starts to create a vicious circle of sell offs and a long period, possibly decades, of deleverage (an entire society paying off their debt and so not consuming) starts.

What role do people play in creating financial crises? How can education help create more economic stability in the future?
When after a deep crisis eventually the economy becomes quiet and stable, and financial markets gradually start to rise, people fall prey to overconfidence-bias and a kind of simple trend-following behaviour: the more days and years in a row a market rises, the more likely people want to step in and profit from the ever rising markets.

Their perception of risk declines, just when risk increases. This increase in demand when prices rise creates a positive feedback loop. It leads to instability and we cannot prevent this from happening by training these individuals. Cognitive science teaches us that it is difficult to de-bias individuals. We can however try to train institutions who deal with individuals (banks, insurers) and the supervisors of these institutions and ministries etc. So education at universities leads to better trained professionals in institutions that have the responsibility to protect the individuals.

How can we make financial matters less of a gamble?
Individually, it is very difficult to reduce these behavioural tendencies and biases. It is known by psychologists that only organisations (e.g. financial regulators) are able to protect themselves from human errors if they are aware of human behaviour. But if regulators receive the same economic training about economic agents being rational all the time, they won’t use these protective procedures. So we need different education, first of all.

What drives you to spread your message about the state of the economic world?
I am disappointed by the state of economic science. It assumes human behaviour that is not in line with what we observe, it abstracts from issues like debt that strongly influence peoples’ behaviour and so on. And worse still: it acts according to its own postulated assumptions about how the world works.

Assuming that bubbles don’t exist made policy makers allow for more lending to poor people and young families, who eventually got hit by the combination of falling house prices and too much debt.

Assuming that we can measure risk by measuring volatility made everyone think risk was low because volatility was low. Therefore, banks were allowed to take on more and more risky exposures. But risk can run contrary to these simple market statistics, but that is not what the mainstream financial “science” teaches us and so economic science helped the economy (regulators, banks, central banks) to look away while risk was reaching its peak.

How did you come to work with Terry Jones and create your film?
I met Terry in 2009 via a good Canadian friend, Rob Buckman, who worked with the Pythons before. We made a small film for the tenth anniversary of my firm, Cardano. Terry and I stayed in touch, and in 2012 Terry read my inaugural speech “Endogenous Instability” and suggested we should make a documentary out of this story of human behaviour and economic developments.

You focus a lot of your efforts on students. How can your film and your ideas reach graduates and professionals, and how can they apply them?
We reach professionals the same way we reach students: screenings at central banks, ministries, financial institutions. But they will also get access to the film via television and Netflix and online in the future.

I hope it teaches them that the world is less stable than we think it is, and that we need to prepare for the consequences of huge financial events, not rely on alchemist beliefs about markets. It would be great if economists understand predictions they produce are as scientific as astrology, but more harmful.

Less reliance on statistics of recent market movements and more on common sense indicators like price/earnings ratios and issues like debt growth in sectors etc. Real risk management is not simple maths around past statistics—the world can change overnight and make the statistics misleading—but the inconvenient process of qualitative and quantitative analysis where a confluence of factors may produce a high risk alert.

You recently visited Maastricht for the Maastricht Symposium where your film was screened. What kind of reaction did you get from students and faculty?
I was overwhelmed by the great and intense discussions I had at the Maastricht University. Students really care about the quality of their curriculum. The huge attendance of students was also amazing; I think around 600 students attended in two sessions, which was great.

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