Interview : Prof. Dan Ariely, Duke University, North Carolina

Behavioral economist Dan Ariely on Housing Bubble and efficient market hypothesis...

 

ACEMAXX-ANALYTICS:

There was a Housing Bubble back then. But why could the most people not be worried? What lessons emerge from that development ?

I don’t think it is the case that most people are not worried. There is a difference here between the regular people and the bankers. If you believe that the stock markets were 2009 was relatively good year especially after 2008. If you want to believe that the world has not changed in fundamental ways, you can try to use that. And you can try if you are a banker. You can try to justify your salary and you can try to justify your income and the structure of the banks and so on. I think for most regular people who are not in the banking industry the housing bubble has not passed at all. They are still incredibly concerned. 

Mostly the people have lost their trust in the banking system for a good reason. 2008 has shown us lots of weaknesses in banking. That time there was a hope there would be a true reform in the banking system in the US and also in Europe. Of course the reform that has taking place has been relatively minute since than. It is good for people who are actually working in the banking industry, not so good for every body else.

I think we have not finished seeing the downfall of this financial recession. I think it will take a long time before people actually regain trust in the financial system. While people within the financial system want to pretend that nothing really happened and the world is back to normal. This is not the case. We will keep on paying it for many years for this recession in terms of how much of the public trust has been lost.

The Efficient Market Hypothesis (EMH) is now being recognized as one of the most remarkable errors in the history of economic thought. Who should safeguard financial stability?

I think the EMH is an interesting hypothesis. And it is interesting possibility. But of course what it is clear is that there are lots of conditions to take place for it to occur even theory. Those conditions are very unlike to occur in reality.

We need to separate economic ideals from economic practicality. One of the things what always amaze me is that one of the simplest theory in economics not EMH, which is complex, but one of the simples one saying when you compete in a market on a commodity in a competitive market prices should go down to productions costs. Basically margins of profits should be eroded in an approach zero.

Here we have the banking industry which is a commodity as much as you can have a commodity. There is a high competition because there are lots of players in the market. Nevertheless it is hard to claim anyway that prices in this market have been approaching production cost. In fact we know that banks make lots of lots of money. Even in the banking sector have shown very simple theories just don’t play out in the way they suppose to.

To the more complex part of your question: Who should safeguard the financial stability? I think the first thing we need to recognize is that we really don’t understand how the financial markets work. If you believe in the EMH, you at least have a theory how the market work. But if you don’t, you have to recognize how the markets work. So now we are working in a really high area of uncertainty and ambiguity.

Secondly what we need to recognize is that this is the world we can create lots of lots damage for ourselves, like we see now. So what do you do in the world in which you don’t understand and you have potential for creating lots of lots of damage. The answer is you have to be cautious and be carefully. You cannot take crazy risks. If that the case, can we hope the companies would regulate themselves? Can you hope individuals would regulate themselves under those conditions. The answer is no. So I think it is much like driving. We need to have external regulations on the markets prohibit people from taking crazy risks. Roads are dangerous and people can create tremendous damages for themselves and as to others much like the financial markets. Because of that we cannot trust people to do right thing on their own court. Instead we need to create some regulatory frameworks that would limit people’s ability to inflict damages on themselves and on others.

I also think that one of the biggest culprits, one of the biggest contributors to the financial crisis has been conflict of interest. When you pay people a lot of money for surreality in a skewed way because it is good for them, you bet you will be able to do it. This is what happened. We paid people a lot of money to be able to surreality in a skewed way. And somehow unsurprisingly, perhaps, they were able to do that. What we need to do is we need to make sure that people are not motivated to surreality in a skewed and in accurate way. We need to stop paying people in ways that they don’t create dramatic conflict of interest. Unless we do that, I don’t think we will get over the problems. The answer is basically a different regulatory frame work and reduction and hopefully elimination of the conflict of interest in the financial systems.