David Leiser and Yhonatan Shemesh’s How We Misunderstand Economics and Why it Matters: The Psychology of Bias, Distortion and Conspiracy

From a new(ish) book by David Leiser and Yhonatan Shemesh, How We Misunderstand Economics and Why it Matters: The Psychology of Bias, Distortion and Conspiracy:

Working memory is a cognitive buffer, responsible for the transient holding, processing, and manipulation of information. This buffer is a mental store distinct from that required to merely hold in mind a number of items and its capacity is severely limited. The complexity of reasoning that can be handled mentally by a person is bounded by the number of items that can be kept active in working memory and the number of interrelationships between elements that can be kept active in reasoning. Quantifying these matters is complicated, but the values involved are minuscule, and do not exceed four distinct elements …

LTM [long-term memory] suffers from a different failing.  … It seems there is ample room for our knowledge in the LTM. The real challenge relates to retrieval: people routinely fail to use knowledge that they possess – especially when there is no clear specification of what might be relevant, no helpful retrieval cue. …

The two flaws … interact with one another. Ideas and pieces of knowledge accumulate in LTM, but those bits often remain unrelated. Leiser (2001) argues that, since there is no process active in LTM to harmonize inconsistent parts, coordination between elements can only take place in working memory. And in view of its smallness, the scope of explanations is small too. …

Limited knowledge, unavailability of many of the relevant economic concepts
and variables, and restricted mental processing power mean that incoherencies are to be expected, and they are indeed found. One of the most egregious is the tendency, noted by Furnham and Lewis (1986) who examined findings from the US, the UK, France, Germany, and Denmark, to demand both reductions in taxation
and increased public expenditure (especially on schools, the sick, and the old). You can of course see why people would rather pay less in taxes, and also that they prefer to benefit from more services, but it is still surprising how often the link between the two is ignored. This is only possible because, to most people, taxes and services are two unrelated mental concepts, sitting as it were in different parts of LTM, a case of narrow scoping, called by McCaffery and Baron (2006) in this context an “isolation effect.”

Bastounis, Leiser, and Roland- Levy ( 2004 ) ran an extensive survey on economic beliefs in several countries (Austria, France, Greece, Israel, New Zealand, Slovenia, Singapore, and Turkey) among nearly 2000 respondents, and studied the correlations between answers to the different questions. No such broad clustering of opinions as that predicted by Salter was in evidence. Instead, the data indicate that lay economic thinking is organized around circumscribed economic phenomena, such as inflation and unemployment, rather than by integrative theories. Simply put, knowing their answers about one question about inflation was a fair predictor of their answer to another, but was not predictive of their views regarding unemployment.

A refreshing element of the book is that it draws on a much broader swathe of psychology than just the heuristics and biases literature, which often becomes the focus of stories on why people err. However, I was surprised by the lack of mention of intelligence.

A couple of other interesting snippets, the first on the ‘halo effect’:

The tendency to oversimplify complex judgments also manifests in the “halo” effect. … [K]nowing a few positive traits of a person leads us to attribute additional positive traits to them. … The halo effect comes from the tendency to rely on global affect, instead of discriminating among conceptually distinct and potentially independent attributes.

This bias is unfortunate enough by itself, as it leads to the unwarranted attribution of traits to individuals. But it becomes even more pernicious when it blinds people to the possibility of tradeoffs, where two of the features are inversely correlated. To handle a tradeoff situation rationally, it is essential to disentangle the attributes, and to realize that if one increases the other decreases. When contemplating an investment, for instance, a person must decide whether to invest in stocks (riskier, but with a greater potential return) or in bonds (safer, but offering lower potential returns). Why not go for the best of both worlds – and buy a safe investment that also yields high returns? Because no such gems are on offer. A basic rule in investment pricing is that risk and return are inversely related, and for a good reason. …

Strikingly, this relation is systematically violated when people are asked for an independent evaluation of their risk perception and return expectations. Shefrin (2002) asked portfolio managers, analysts, and MBA students for such assessments, and found, to his surprise, that expected return correlates inversely with perceived risk. Respondents appear to expect that riskier stocks will also produce lower returns than safer stocks. This was confirmed experimentally by Ganzach (2000). In the simplest of his several experiments, participants received a list of (unfamiliar) international stock markets. One group of participants was asked to judge the expected return of the market portfolio of these stock markets, and the other was asked to judge the level of risk associated with investing in these portfolios. … The relationship between judgments of risk and judgments of expected return, across the financial assets evaluated, was large and negative (Pearson r = −0.55). Ganzach interprets this finding as showing that both perceived risk and expected return are derived from a global preference. If an asset is perceived as good, it will be judged to have both high return and low risk, whereas if it is perceived as bad, it will be judged to have both low return and high risk.

And on whether some examinations of economic comprehension are actually personality tests:

Leiser and Benita (in preparation) asked 300 people in the US for their view concerning economic fragility or stability, by checking the extent to which they agreed with the following sentences:

1. The economy is fundamentally sound, and will restore itself after occasional
crises.
2. The economy is capable of absorbing limited shocks, but if the shocks are
excessive, a major crisis and even collapse will ensue.
3. Deterioration in the economy, when it occurs, is a very gradual process.
4. The economy’s functioning is delicate, and always at a risk of collapse.
5. The economy is an intricate system, and it is all but impossible to predict how it will evolve.
6. Economic experts can ensure that the economy will regain stability even after
major crises.

These questions relate to the economy, and respondents answered them first. But
we then asked corresponding questions, with minimal variations of wording, about
three other widely disparate domains: personal relationships, climate change, and health. Participants rated to what extent they agree with each of the statements about each additional domain. The findings were clear: beliefs regarding economic stability are highly correlated with parallel beliefs in unrelated social and natural domains. People who believe that “The economy’s functioning is delicate, and always at a risk of collapse” tend to agree that “Close interpersonal relationships are delicate, and always at a risk of collapse” … And people who hold that “The economy is capable of absorbing limited shocks, but if the shocks are excessive, a major crisis will occur” also tend to judge that “The human body is capable of absorbing limited shocks, but beyond a certain intensity of illness, body collapse will follow.”

What we see in such cases is that people don’t assess the economy as an intelligible system. Instead, they express their general feelings towards dangers. … [T]hose who believe that the world is dangerous and who see an external locus of control see all four domains (economics, personal relations, health, and the environment) as unstable and unpredictable. Such judgments have little to do with an evaluation of the domain assessed, be it economic or something else. They attest personal traits, not comprehension.

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