By George A. Akerlof & Robert J. Shiller
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Transcript
(video George A. Akerlof: on Phishing for Phools: The Economics of Manipulation and Deception)
Okay, so let me give a more precise definition of phishing for our purpose. So phish is a recent word. It’s computerese. And free markets open us up to those who seek to influence us to do what they want, but that’s not necessarily good for ourselves. They allow us, in other words, to be phished. And so this is particularly appropriate for the Peterson Institute we live in a world where some five billion adults can phish us for being a phool.
So we intentionally opened ourselves up to such exploitation because of the obvious advantages, but then we must also think about the other side of the board. So what is a phool with a PH?
A phool simply is someone who is successfully phished. And our view of a phool is everybody’s a phool. We all have our weaknesses, we all have our weaknesses some place, and so a phool is in some sense an intelligent person, a phool is in some sense just somebody who’s human.
Okay, so the onus is now on us. The onus is on Bob and myself in the book to indicate that in real life this equilibrium does affect our lives. So, you know, I must confess before I wrote this book, I always thought pretty much, all the decisions that we made the right decisions pretty much, subject to all kinds of problems of information and that .
But actually having written this book, I’ve actually changed my mind. Now, of course, I spent five years writing this book and Bob has spent five years and we’ve had a research assistant. But the fact is, I seriously believe that this is a major problem and I’m going to give you four reasons why. There are four areas–so if there are four areas of what we call, “Nobody could possibly want.” And I’m going to give you those four areas.
First is personal financial insecurity. Fundamental fact of economic life has never made it into the economics textbooks. Most adults, even in rich countries, go to bed at night worried about how to pay the bills. Economists think that it’s easy for people to spend according to budget. But we shall see later that it isn’t. Now no one wants to go to bed at night worried about the bills, but most people do.
Area two of nobody could possibly want is financial and macroeconomic instability. So phishing for phools in financial markets is the leading cause of the financial crises that lead to the deepest recessions. So in the 1920s, it was Swedish Matches with Ivar Kreuger of Kreuger and Toll. In the 1990s it was the dot coms and in the 2000’s, it was subprime mortgages with Angelo Mozilo of Countrywide and his like.
So every time it is different, the stories are different, the entrepreneurs are different and their offerings are different, but also every time it is the same. There are the phishermen and there are the phools. And when the buildup stock of undiscovered phishes named the Bezel by John Kenneth Galbraith gets discovered, asset prices crash.
So on the last crisis the investment managers who had purchased the packages with the bad mortgages in the buildup to the crash, could not have possibly wanted them. And so, we shall return later to that in the talk. So area three of nobody could possibly want is ill health. Here we discuss how the pharmaceuticals do their phishing and how the phood industry (with a PH) fills us with sugar, salt and fat. In its five year career just to give you one example. Vioxx is estimated to have caused 26,000 to 56,000 cardiovascular deaths in the United States alone. Failure to notify women of suspicions about Premarin, a hormone replacement, is estimated to have caused some 94,000 cases of breast cancer. So nobody wants bad medicine.
About 69 percent of American adults are overweight and more than half of them, 35 percent, are furthermore obese. Yet no one wants to be obese. And then there is tobacco; no one wants lung cancer and then there is alcohol; no one wants to be an alcoholic.
Okay, so bad government. Just as free markets work at least tolerably well under ideal conditions, so does democracy. Politics is vulnerable to the simplest phish whereby politicians silently gather money from the interest and use that money just to show that they’re just one of the folks.
So our later chapter gives the example of a campaign by Charles Grassley of Iowa, who gathered a multimillion dollar war chest. And then he showered the state with TV ads where he’s just one of us back home and he’s riding his tractor lawn mower in concentric ellipse and just showing the people back home that he’s just like them with his tractor lawnmower.
And also, he has the most beautiful lawn, you know, it’s just a beautiful picture. There’s a marvelous red barn in the backyard and there’s Grassley, you know, and you see this beautiful grass emerging.
So almost no one wants a democracy where elections are bought in this way. I think I’m going to skip the next two slides; these are the slides about the 19th century before we had regulation and then I take you to something meatier. So this takes us to the first major chapter of the book. So as we all know, probably everybody here recognizes this person. Susie Orman is a popular TV figure and as we all know, if we’ve ever watched her for more than a few seconds, she gives very loud and shrill financial advice. But, her audience seems to adore her and lap up every word. So when I asked an economist friend of mine at the IMF about her, he had the predicted reaction. He had watched her for only 10 seconds and he simply could not stand her “Mommy knows best” voice.
Furthermore, he found her investment advice simplistic, which I don’t know how he managed it in his 10 seconds, but I think he did. But that does not explain why Susie Orman’s audiences lap her up. Her most popular book is called, “The Nine Steps to Financial Freedom; Practical and Spiritual Steps So You Can Stop Worrying.” So let’s contrast what she tells us there with a portrait given of consumer spending in the Economics textbooks.
So according to Economics textbooks, we decide on our demand for the proverbial apples and oranges by having a budget for our spending and then we choose the combination of apples and oranges along there that will maximize our happiness, that maximize our utility. But Susie Orman’s financial advice books tells us the consumers do not follow such a textbook protocol in their purchases. So how could consumers do anything better than what the textbooks describe?
Well, I’m an economist, I couldn’t imagine not doing–and I think, when I do go to the supermarket, I do that stupid thing that we’re told to do in the textbook. But she tells us that people actually do something different because people have emotional hang ups with regard to money and with regard to spending it.
So what she found, as a financial advisor, is that they’re not honest with themselves and as a consequence, they do not engage in rational budgeting. Well how could she know? Well, as a financial advisor, she had a test. She asked her advisees to add up their expenditures and those expenditures all but invariably fell short of what a documented accounting from the record later turned up.
So figuratively what were people doing? So relative to the proverbial trip to the supermarket to buy those apples and oranges, it’s as if her advisees spend too much in the fruit section. And by the time they reach dairy products, there’s nothing left over for eggs and milk.
So in real life, such budgetary failure translates into having nothing left over for saving. So this failure, this failure to deal cognitively and emotionally with money, says Orman, leads to those unpaid bills. So it’s her mission to keep those bills down, so that her readers and her clients will no longer worry at night. So that’s the role of Mommy and also why those audiences excuse that Mommy knows best.
So it’s worth noting and this is more than parenthetical that worry, as noted in Orman’s subtitle, are central concerns of the financial advice books, but you will never find that in the index of an economics textbook. So we don’t just need to take Orman’s word for it, we can put together a statistical story and that indicates that a very significant fraction of consumers are worried about how they’re going to make ends meet.
So a paper by Annamaria Lusardi asked the question, “How confident are you that you could come up with $2000 if an expected need arose within the next month.” So almost 50 percent of US respondents replied either that they could not or they probably could not come up with the needed $2000 dollars, even though they were being given a whole month to do so.
The same difficulties regarding finances can be gleaned from a survey of consumer finances. In 2004 a rough accounting indicates an average of about $10,000 of financial assets held by the bottom 50th percentile of the population and most of those financial assets were then liquid in some way or other.
For British workers paid once a month, their expenditures are down a remarkable 20 percent in the week before their next paycheck. And then we have the number of bankruptcies. By my estimate, there is something like a 20 percent chance that someone in the United States will go bankrupt over the course of their lifetime.
And there’s a sociologist at Harvard who has estimated for Milwaukee the chance of being evicted per year for the whole population of Milwaukee and he finds that to be 2.5 percent, which is really amazing. Actually I believe he’s made an over estimate, but even if it’s half that, it’s still an amazing thing to have 1-1/2 percent that you’re going to be a poor person out on the street, 1-1/2 percent per year.
That means over a ten-year period, you’re going to have 15 percent of the whole population of Milwaukee. So I’m doing half of his number and 15 percent of the population is going to have that terrible thing happen to them.
Okay, so this poses a problem, a theoretical puzzle. The Susie Orman view of the world suggests that people are spending too much and they’re worried as a result. So that leaves the question why. So there’s another perspective on this. So back in 1930, John Maynard Keynes wrote a short essay on what life would be like for our grandchildren 100 years later.
In one respect, Keynes was totally correct, he predicted that real income would be some eight times higher. So far income has increased six times and he’s right on target for 2030. But in another respect, Keynes was totally off the mark. He did not predict that the grandchildren would be going to bed worried about their next shilling. Instead, he said they would be worried about how to use their surfeit of leisure. I see everybody in this room and their respective spouses worried about their surfeit of leisure.
So he failed to predict the housewife who was exhausted from the first and then from the second shift. But the perspective our book coupled with listening to Susie Orman, gives us the reason for this.
So what’s the answer to the puzzle? Well, we know the answer to the puzzle, it’s there in this general equilibrium theory. So, in some sense, what we think we’re doing in this book, I always thought general equilibrium theory was rather dull and boring. But for me, writing this book has brought general equilibrium theory to life.
So in the United States the goal of almost every business person is to get you to spend your money. So life in a capitalist economy is a continual temptation. So think about it, just walk down a city street, walk down Connecticut Avenue. The shop windows are literally there to make you come in and buy.
An example comes from the old days. In the US in the old days, I’m old enough to remember that Pet Shops used to have puppies in the window and you were supposed to see those puppies and you were supposed to come in and buy, they were so cute. And so there’s even a popular song about it. So Patti Page, the singer, coming down the street, sees such a puppy and so she bursts into song. She sings, “How much is that doggie in the window, the one with the waggly tail. How much is that doggie in the window, arf arf, I do hope that doggie’s for sale.”Well, you’re not going to buy the book because of my singing, but the remarkable thing about that song, that song is about the fact that they have that doggie in the window and they’re going to entice you to a sale.
Now the remarkable thing that I didn’t realize, actually probably until after the book was written, was that the rest of the song fits our book just totally magnificently because our book is about the two sides of markets. They’re wonderful, they give us what we want. It’s really tremendously amazing that all of the luxuries that markets give us and that they’ve developed just in the last 150 years.
But then, there’s this bad side to markets. So let me tell you about the subsequent verses. So in the subsequent verse, she says, “I’m going to take a trip to California and leave my poor sweetheart alone. If he has a doggie he won’t be lonesome and the doggie will have a good home.” And then she goes on, she continues with her song, it’s very nice though.
Okay, now think about it, okay. The interesting thing about this song is that it has this ambiguity to it. On the one hand, this may be the most lovely young woman in the world and she has to go to California and there she has this wonderful love affair with this boyfriend and she’s going to buy the doggie. And every time that the boyfriend sees the doggie, he’s going to have a memory of this wonderful love affair he has with this wonderful woman.
So that’s story one. But there’s also the other side to this story. Here’s this scatterbrain woman, she’s leaving this guy. It’s been a disastrous affair. She goes off to California and there he is left with this doggie and this poor guy, he doesn’t know what to do with the darned thing. He has to walk it, he has to take care of it, and every time he sees it and the doggie wags its tail, he’s reminded of this failed love affair. So there you are. But that’s the point of the song is that markets have these two sides and that’s the point of our book.
So that’s the first message. So in the shopping mall and in the supermarket, temptation is there. These invitations, these attempts to lure us are simply pervasive. So they’re there when we rent an apartment, when we buy a car, when we buy a house, every time we use our credit card. So the idea of tempting the consumer to buy to spend your money is at the heart of free market capitalism.
Okay, so that’s the first story. Let me give you a second story, so that’s endemic temptation, I’ll talk about the financial crisis, let me see. I’m doing okay for talk.
So there are hundreds of books on the financial crisis. The typical one is 500 pages long. The typical one, as I’m sure everybody here knows, tells the story of my institution. For example, it’s about Lehmann or GoldmanSachs or Fannie Mae-Freddie Mac or the Fed or Treasury or Bank of America or City Corps and they go on and on and on forever and they’re also very good–or the best ones are very good.
Implicit in each of these is that my institution is central to the crisis. Now the aim of our chapter on the financial crisis, we have three chapters, which gives us a different feeling for what financial markets are all about. The aim of our chapters on the financial crisis is due to the opposite. So on “The Financial Crisis” is to tell the story of the crisis in general terms. So scratch any economist and we will go into economic speak. So we’re trained to think in terms like supply and demand and this means that we often ask very good questions and that we have good analyses of problems.
So Phishing for Phools, is an offshoot, it’s an offshoot from how we standard economists typically do our analysis. But it’s not so standard—it’s not so standard that every economist was asking the right questions in the build up to the crisis. But we should have been because Phishing for Phools gives us an extremely succinct explanation for what happened and let me give you one rendition for that.
Okay, so a reputation one. If I have a reputation for selling perfect, beautiful avocados, I have an opportunity. I can sell you a rotten avocado at the price you would pay for the perfect ripe one. I will have mined my reputation, but I will have also phished you for a phool. So there we have the avocado.
So, such a story lies at the heart of the continuing financial crisis that dominates the economics of our times. The reputation mining in question involved the subversion of the system for rating fixed income security. So the reputations of the ratings agencies; Moody’s and Standard and Poor’s, have been built up over the course of almost a century. Their job was to rate bonds on their probability of default.
In the late 1990s and early 2000s the ratings agencies took on themselves the task, not just of rating bonds, but of also rating more complex derivative securities. The complexity of the payment structures made them somewhat hard to rate, but something else made rating all but impossible. The underlying assets such as mortgages were all but inaccessible to the raters. But the public, the public out there would believe whatever ratings were given to them by the agencies.
And an industry then grew up, an industry grew up to do a reputation mine. So by analogy, by analogy rotten avocados were being labeled perfect and with that label they commanded premium prices and so what happened was a whole a Central Valley full of growers went into the profitable business of producing such avocados. So this mining of the ratings is the basic story, that’s the basic story of the financial crisis.
Well that’s not all of the story as you all know. It’s not all of the explanation. So we must also explain why the production and sale of those over rated securities brought down the financial system. And the answer again is simple. The value of these securities reflected these ratings. So that enabled commercial banks and investment banks, and also hedge funds to borrow huge amounts of money short term. Invest in the over rated securities and pocket small profits from the interest spread on every dollar of investment. They took on a lot of leverage.
So that borrowing was made with the rotten securities as collateral. For the moment, they seemed as good as gold. The ratings indicated that there was almost no chance of default. But then, as we all know, the truth was discovered. Those avocados perfect as they were on the outside, were really rotten on the inside. So they were worth much less than the bankers and finance managers had paid for them. And so from Frankfurt to New York to Rakeovic, financial institutions owed much more than they owned.
Without bailouts, they were bankrupt.So, the chapter then gives the historical answer to four questions.
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