“There were Exactly Five People Who Foresaw This Crisis”

Daniel Kahneman on economic models:

Irrational everything, by Guy Rolnik, Haaretz: Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people’s irrational behavior when it comes to making economic decisions. … But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, “We suddenly found a map.” The officer looked at the map and said, “You found a map, all right, but it’s not of the Alps, it’s of the Pyrenees.”

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security – maps of the Pyrenees – even if they are, in effect, worthless. …

“In the last half year, the models simply didn’t work. So the question arises: Why do people use models? I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can’t predict hurricanes. Do we use the system anyway, or throw it out? It turns out they’ll use it.”

Okay, so they use it. But why don’t they buy hurricane insurance?

“The question is, how much will the hurricane insurance cost? Since you can’t predict these events, you would have to take out insurance against many things. If they had listened to all the warnings and tried to prevent these things, the economy would look a lot different than it does now. So an interesting question arises: After this crisis, will we arrive at something like that? It’s hard for me to believe.”

The financial world’s models are built on the assumption that investors are rational. You have shown that not only are they not rational, they even deviate from what is rational or statistical, in predictable, systematic ways. Can we say that whoever recognized and accepted these deviations could have seen this crisis coming?

“It was possible to foresee, and some people did. … I have a colleague at Princeton who says there were exactly five people who foresaw this crisis, and this does not include … Ben Bernanke. One of them is Prof. Robert Shiller, who also predicted the previous bubble. The problem is there were other economists who predicted this crisis, like Nouriel Roubini, but he also predicted some crises that never came to be.”

He was one of those who predicted 10 crises out of three.

“Ten out of three is a pretty good record, relatively. But I conclude from the fact that only five people predicted the current crisis that it was impossible to predict it. In hindsight, it all seems obvious: Everyone seemed to be blind, only these five appeared to be smart. But there were a lot of smart people who looked at the situation and knew all the facts, and they did not predict the crisis.” …

The interesting psychological problem is why economists believe in their theory, but this is the problem with the theory, any theory. It leads to a certain blindness. It’s difficult to see anything that deviates from it.”

We only look for information that supports the theory and ignore the rest. “Correct…” …

Let’s end with your story of the Swiss soldiers and the map of the Pyrenees. I know why the map helped the soldiers: it gave them confidence. But why didn’t they use a map of the Alps? Why don’t we use the right economic models, ones that are relevant to extreme cases as well?

“Look, it’s possible that there simply is no map of the Alps, that there is nothing that can predict hurricanes.”

[full interview]

Originally published at the Economist’s View and reproduced here with the author’s permission.

7 Responses to "“There were Exactly Five People Who Foresaw This Crisis”"

  1. Rohelio   April 21, 2009 at 8:14 pm

    This is similar to a western version of the Sufi story of the man who is looking for his lost keys in the light of a streetlamp. A friend asks him where he may of lost his keys. The man points to spot distant.”Then why are you looking in this spot?”He answers, “because this is where the light shines”

  2. Ismael   April 23, 2009 at 10:48 am

    The Economist published around mid 2005 a special report on the looming real estate crash, predicting exactly what has happened, the biggest asset bubble ever, fed mostly by the loose practices of US mortgage lenders, would cause a major financial crisis and a severe global (almost)recession and deflation. I’ve never seen it mentioned among the few publications that gave early warning (they were a bit early in their timing actually, those bubbles tend to keep growing beyond the wildest expectations), which makes me sometimes wonder if I didn’t in fact dream reading that article (I’ve had a few dreams consisting in reading a whole book that I invent as I go along).And I don’t remember The E. ever predicting a crisis that didn’t happen.Whatever, I considerably downsized my real estate holdings in 2005 and 2006.

  3. Guest   April 24, 2009 at 1:45 am

    Lot’s of people have been writing about the upcoming crisis for years. I used to study with Michael Pettis when he taught at Columbia and he wrote and lectured several times about how we were in a liquidity cycle and how it would inevitably end in a huge mess. If I remember right his Foreign Policy article in 2002 (I think it was called Globalization Will Go Bankrupt) even described what previous end-of-globalization crises had in common and why this one would be the same. His hedge fund colleague (Conor Egan?) spoke at the class and was even more vehement about how it would all collapse. Basically I think every person who had a strong background in finance history took it for granted that it would end terribly.

  4. Guest   April 24, 2009 at 8:57 am

    This whole article is preposterous. There were dozens of people I have read, and since I certainly don’t read everyone, I would even say hundreds if not thousands of people who predicted, this. I had a job offer in California in 2006. I spent 1/2 a day looking at houses in the Central Valley, and immediately predicted that there would be a huge crash in housing, and since Fannie Mae and Freddie Mac had been in the news consistently about their dubious financial condition, I told my wife, my father in law, and others of the crisis that was brewing. And I wasn’t telling anyone anything new. Most common people who had worked for 30 years or more in the building industry, or who study international finance knew that you couldn’t continue to have both a huge fiscal deficit and current account deficit forever, and that our housing market was an obvious bubble. This was the easiest crisis to see that has happened in the last 70 years. Even the internet bubble wasn’t as obvious. There were hundreds of investors who were accurately calling it a bubble, but at the same time, the argument that the advent of the internet had literally caused a step-change increase in productivity was somewhat believable. This was something revolutionary that fundamentally changed the way many people did business. However, many, many people who study the market called it for the ordinary speculative bubble that it was. The idea that a non-productive asset like a house could actually gain in value at a rate much greater than inflation was a stupid suggestion, and I could name 30 people who called that bubble for exactly what it was. Give me an hour on google, and I’ll find you 500 people who called the collapse between 2005 and 2007. The problem is that you only expose yourself to a narrow set of viewpoints. Start reading some libertarian, Austrian economics, sound currency, and other pages with views that are more contrarian to the popular flow. You obviously read Roubini, and he certainly has some great insight and knowledge, but he is still generally in the mainstream of thought. As long as you stay in the middle of the river, you will only see those right around you.”…it was impossible to predict.” HA!!!!

  5. paul94611   April 25, 2009 at 10:23 am

    The author seems lost on a basic fact of human relationships. That is humans are far more likely to remain loyal to their construct of the environment they live in than to remain loyal to their own spouse when it is their relationship with their spouse that remains the ultimate partnership in life.

  6. Guest   April 26, 2009 at 8:35 am

    The interpretation of the map story illustrates a blind spot in logic, not of the soldiers but of Professor Kahneman and Mark Thoma. Mountainous terrain imposes limitations on where people could likely maintain sucessful permanent communities. Failure to choose a good location could be fatal so those communities that exist have to be in locations that will be sustainable. Such sustainable locations will very probably have the same characteristics in any set of mountain ranges. Recognizing this would mean that a map showing the relationship of the mountains of the Pyrennes and their sustainable communities would offer important information about the likely location of where a sustainable community in the Alps might be in relation to its mountains. Thus if all the communities of the Pyrenees are located in the valleys it might make better sense to head for the nearest vally in the Alps to find a community. So the metaphor is false which brings into question the logic behind the author’s article.

  7. Guest   April 26, 2009 at 7:57 pm

    I agree with you, is there a fault in economic models? if their continues to be economic cycles of booming, and busts that seem to get larger every time? Why does society use these? Is it because we are still primitive and rely on agriculture form of cycle that transitioned to an economic cycle?You definitely pinpointed a very good discussion. Do we need to rewrite the economic books and update economic models that are more curtailed to that of the 21st century.Technology has taken use great lengths further than anyone in the passed could of ever predicted. I agree we need better maps. And how do we create new ones if we are constantly are indebted to the old ones?And without sufficient access to economic models that predict these busts, are we doomed to even face larger ones in the future?I really do like Ben, the “trickle down economics” is not his baby, But Ben has to care for it.Finally, there are many that predicted this economy,(including me in 1999).