By George A. Akerlof & Robert J. Shiller
George A Akerlof was born in New Haven, Connecticut, United States, the son of Rosalie Clara Grubber (née Hirschfelder) and Gösta Carl Åkerlöf, who was a chemist and inventor. His mother was Jewish, from a family that had emigrated from Germany. His father was a Swedish immigrant. Akerlof graduated from the Lawrenceville School in 1958 and received the Aldo Leopold Award in 2002. In 1962 he received his BA degree from Yale University, in 1966 his PhD degree from MIT and taught at the London School of Economics 1978–80.
He won the 2001 Nobel Memorial Prize in Economic Sciences (shared with Michael Spence and Joseph E. Stiglitz).
In his 2007 presidential address to the American Economic Association, Akerlof proposed natural norms that decision makers have for how they should behave, and showed how such norms can explain discrepancies between theory and observed facts about the macroeconomy. Akerlof proposed a new agenda for macroeconomics, using social norms to explain macroeconomic behavior
His wife, Janet Yellen, was the Chair of the Board of Governors of the Federal Reserve System and professor emeritus at Berkeley’s Haas School of Business.
Robert James Shiller (born March 29, 1946) is an American economist (Nobel Laureate in 2013), academic, and best-selling author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management‘s International Center for Finance. Shiller has been a research associate of the National Bureau of Economic Research (NBER) since 1980, was vice president of the American Economic Association in 2005, its president-elect for 2016, and president of the Eastern Economic Association for 2006–2007.He is also the co‑founder and chief economist of the investment management firm MacroMarkets LLC.
Eugene Fama, Lars Peter Hansen and Shiller jointly received the 2013 Nobel Memorial Prize in Economic Sciences, “for their empirical analysis of asset prices.
He is married to Virginia Marie (Faulstich), a psychologist, and has two children.
Morris Goldstein: Good afternoon and welcome to the Peterson Institute for International Economics. My name is Morris Goldstein. I have been a Senior Fellow at PIIE since 1994 and I will be standing in for Adam Posen as Host for today’s event. We are in for a treat. Our speaker is Professor George Akerlof of Georgetown University. George is going to introduce his new book, co-authored with his friend and fellow Nobel Laureate Robert Shiller of Yale University called Phishing for Phools. George doesn’t really need an introduction, but I will provide a very short one, nevertheless.
He is a University Professor at Georgetown, which he joined in November 2014. Before that, he was the Professor of Economics at the University of California at Berkeley, where he has taught since 1966. In 2006, he was President of the American Economics Association and in 2001; he received the Nobel Prize in Economics for his work on Asymmetric Information and its Effect on Economic Behavior.The game plan is as follows: George will speak for about 40 minutes. We will then turn to our distinguished audience for questions and after the Q&A, there will be a book signing for those of you who wish to purchase Phishing for Phools. So without further ado, George tell us about your new book.
George Akerlof: Thank you very much, thank you for having me, thank you everybody for coming. I really appreciate it.So, we have this new book, it’s called Phishing for Phools and it has a very good cover, which is drawn by Ed Koren who’s a New Yorker cartoonist. So, the official publication date is tomorrow. So I guess today is the 21stand the 22nd is supposed to be THE DAY. It’s meant to be a popular book, but actually, it’s more than a popular book, because it is actually a book that does question lots of the foundations of economics.
There are two reasons why we made it into something that we hope is popular. The first is that we are influenced we think more than we think by popular books. And the public and economists have too great an acceptance, we think. This is our major message, of the view that whatever markets do is right. So that’s the major question that we address. Of course, all of this would take into account the standard externalities in income distribution. But that does not exhaust the reasons why competitive markets yield bad outcomes. So this book is going to explore the following notion; the notion that markets deceive us and manipulate us. So we have a name for this, we call this Phishing for Phools. Now all economists know this. Everybody here in this room knows this, but that leads to the second very general motivation.
The rule of what can and cannot be published in Economics leaves holes. There’s some perfectly valid and important things to say, but there’s no way to say them that would be acceptable in any economic journal.For example, quite a few economists, maybe quite a few in this room, thought that financial derivatives would lead to the current crisis. But economists could not figure out, we could not figure out a way to express these views in the form of a paper. So, I believe, that Phishing for Phoolsis one of those holes in Economics because we all know it, because everybody in this room knows it, it cannot be published. But because it cannot be published in journal form, then it gets ignored. And because it was ignored, we had the financial crisis and the financial crisis is the central event in the economic history of our time.
But then, the book also has a subtext. So there’s an important subtext, which gradually becomes increasingly important as the book proceeds and I’ll get to that at the very end. So I’m going to come to that at the very end, so that’s a reason for staying till the end and seeing what there is. And I think that’s also reason for reading the book beyond the talk because as a crescendo, this subtext becomes much more important and, I think, it’s actually one of the fundamental things that’s missing to almost all economic analyses as we know it. Okay, so with these preparatory notes, okay, those preparatory notes, let me begin.
The book is based on conversations with Danny Kahneman some 25 years ago. In a conversation then he told me that the basis for Psychology was that humans are machines and they are machines that are prone to error. The job of a psychologist is to ferret out that error. In contrast, he said, the fundamental notion of economics is equilibrium. That equilibrium means that if there’s a profit left on the table, someone will take that opportunity for profit. Now all of us know that and we see it every time we go to the supermarket. There, people sequentially line up and they choose what they think is the shortest line. And in equilibrium then, the lines are almost the same length. So then, the question is how to put Danny’s insight into economics. So Danny’s insight says that free markets will not just provide what we really want.
That is only the case if those human machines are making the right choices. But free markets will also provide us with the wrong choices and they will do so just as long as there’s a profit to be made.So the principle that we’re going to explore means that if we have some weakness, if there is some weakness or other in the equilibrium, that weakness will be taken up. It will be taken up as long as there’s a profit to be made.So what does that mean? That means that among all those businesspersons, figuratively arriving at the checkout counter looking around and deciding where to spend their investment dollars, some will look to see if there are unusual profits from our weaknesses. If they see such an opportunity for profits that will be, again, figuratively the checkout lane that they choose.
So as a result, economists will have an equilibrium. They will have a phishing equilibrium. That’s an equilibrium in which every chance for profit more than the ordinary will be taken up and that will include a willingness to make the wrong choices.
So let me give you three examples. The first example is Cinnabon. So back in 1985, father and son, Rich and Greg Komen of Seattle founded Cinnabon, Inc. and they had a marketing strategy. They would open up outlets that baked the world’s best cinnamon roll.Now Cinnabon has 880 calories, which is a lot, and they have a nice motto, “Life needs frosting.” And you’ll see that frosting there. So the Komens took a great deal of effort to develop their marketing strategy, especially cinnamon, which they chose carefully, is said to attract humans by its smell, just the way pheromones attract moths.
So most of us probably take it for granted—we take it for granted that there just happens to be such an outlet right there where we’re waiting for our delayed flight or at the mall. All those outlets and all that cinnamon, which undermines our diets, they’re a natural result of a free market equilibrium. So just go to Dulles Airport, which is out that way or go to National Airport, which is over there and you’re going to find that there is such an outlet.
Okay, I’ll give you a second example, health clubs. So Stefano DellaVigna and Ulrike Malmendier report from their survey of 7500 Boston health club users that when the customers first went to the health club, they signed into contracts for which they overpaid, okay.
So they would typically be offered three different contracts; they could pay by the visit, they could pay by credit card with automatic monthly rollover unless cancelled, or they could take out an annual contract. Somost customers chose the monthly contract. But 80 percent of them would have paid less by the visit. Furthermore, the losses from this wrong choice were nontrivial. It was $600 per year out of average payments of $1400.
And then, to add insult to injury, a very large number of the clubs put roadblocks in the way of cancelling the contract, such as requiring a notarized letter. Now, of course, the existence of those contracts was no coincidence. They are there for a simple reason, because there was a chance to make a profit, okay.
So now let me give you a third example, and that third example comes from Bob. Now Bob is an utter genius and only Bob could have thought of this. And it always makes me laugh whenever I think about it. So it’s a metaphor and Keith Chen, Venkat Lakshminarayanan, and Laurie Santos taught capuchin monkeys how to use money to trade. Now the monkeys developed an appreciation of price and they saved and they either did other transactions, some of them less savory.
But let’s go beyond those experiments, let’s do a thought experiment. So here’s Bob’s thought experiment. Suppose we open the monkeys up to trading with humans quite generally. We would give a large population of capuchins substantial income and let them be customers of For Profit Businesses run by humans without regulatory safeguards.
Well, you can easily imagine that the free market system with its taste for profits would supply whatever the monkeys chose to buy. So it is spec and economic equilibrium with concoctions appealing to strange capuchin tastes. But amid this monkey cornucopia, their choices would be very different from what makes them happy. So we know from Chen, Lakshminarayanan and Santos that they love sweet fruit rollup tacos with marshmallow fluff.
Well, capuchins have limited ability to resist temptation, so we have every expectation that they would become anxious, malnourished, exhausted, addicted, quarrelsome and sickened.
Okay, so now we come to the point of this thought experiment. We shall see what it has to say about humans. So our view of the monkeys as analyzed, their behavior is if they have two types of what economists call tastes.
The first type of taste are what the capuchins would exercise if they made the decisions that are good for them. The second type of taste, their fruit rollup taste are those they actually exercise. So humans are no doubt smarter than monkeys. But we can view our behavior in the same terms. We can imagine us humans, like the capuchins, as also having two different types of taste.
So, the first type of taste describes what’s really good for us. But as in the case of the capuchins, that’s not always the basis for all of our decisions. The second concept of taste is the taste that determine how we really make our choices and those choices may not in fact always be good for us.
So the distinction between the two types of tastes and the example of the capuchin give us an image. We can think about our economy as if we all have monkeys on our shoulders when we go shopping or when we make economic decisions. And those monkeys that are on our shoulders are in the form of the weaknesses that have been exploited by marketers for ages.
Because of those weaknesses, many of our choices differ from what we really want or alternatively they differ from what’s good for us. So we’re not generally aware of that monkey on our shoulder. So, in the absence of some curbs on markets, we reach an economic equilibrium where the monkeys on the shoulder are substantially calling the shots. So let me now make a note and that is we think, “Oh yeah, the capuchins, humans are so much smarter than the capuchins.”
But you have to remember something, the capuchins can’t read, so how about those advertisements that would be advertising us and they’retricking us, they would mean nothing to the capuchins. The capuchins just go and they take their marshmallow fluffs. We, in fact, we have a whole array of ways in which people can get to us, where they are going to have no effect whatsoever on the capuchins
Okay, so where does this fit into economics. So this really fits into something that’s actually fairly important in economics. So let’s go ahead and I’ll just describe this in more detail.
Adam Smith, as we all know, back in 1776 wrote the following, “That with free markets, as if by an invisible hand, each person pursuing his own interests, also promotes the general good.” Now there’s a modern rendition of this statement and that is that competitive free market equilibrium is Pareto-optimal. So what does that mean? That means that once such an economy is in equilibrium, it’s impossible to improve the economic welfare of everyone. So any interference would make someone worse off.
The theory, of course, recognizes some factors that might blemish such an equilibrium of competitive free markets, such as externalities in bad distributions of income. But with these qualifications, the result is believed to be true. But then with completely free markets, there’s not only freedom to choose, but then there’s also freedom to phish.
Now it’ll still be true, now this is the thing, the Pareto still goes through. It will still be true following Pareto that the equilibrium will be optimal. But it will be an equilibrium that’s in optimal, not in terms of what we really want. It will be in an equilibrium that’s optimal instead of terms of our monkey on our shoulder tastes. And then for the monkeys and for ourselves would lead to manifold problems.
So standard economics has ignored this obvious difference because most economists have thought that for the most part, people do know what they want. That means that there’s nothing much to be gained from examining the differences between what we really want and what those monkeys on our shoulders are instead telling us.
But that ignores something, that ignores the field of psychology, because this whole field of psychology is, or at least most of it is about the effects of those monkeys on our shoulders. It also ignores the fact that the competitive equilibrium will also involve people generating information that will lead us astray insofar as it is legal and insofar as there’s a profit to be made by it. So in terms of our book, markets enable phishing for phools.