Monday, June 8, 2015

What behavioral finance tell us about the Greek negotiations

How would you like a loan at an interest rate of 600%? What rational person would agree to such terms?

Some do. Here is a screenshot of a local payday loan website:

It turns out that extreme stress makes people act in a less than optimal fashion. I came upon this profile of Sendhil Mullainathan, who is a Harvard professor specializing in behavioral finance. Mullainathan found that poverty makes people behave in a less than rational way:
If the mind is focused on one thing, other abilities and skills—attention, self-control, and long-term planning—often suffer. Like a computer running multiple programs, Mullainathan and Shafir explain, our mental processors begin to slow down. We don’t lose any inherent capacities, just the ability to access the full complement ordinarily available for use.

But what’s most striking—and in some circles, controversial—about their work is not what they reveal about the effects of scarcity. It’s their assertion that scarcity affects anyone in its grip. Their argument: qualities often considered part of someone’s basic character—impulsive behavior, poor performance in school, poor financial decisions—may in fact be the products of a pervasive feeling of scarcity. And when that feeling is constant, as it is for people mired in poverty, it captures and compromises the mind.

This is one of scarcity’s most insidious effects, they argue: creating mindsets that rarely consider long-term best interests. “To put it bluntly,” says Mullainathan, “if I made you poor tomorrow, you’d probably start behaving in many of the same ways we associate with poor people.” And just like many poor people, he adds, you’d likely get stuck in the scarcity trap.
That brings me to the point about payday loans:
Take payday loans, for instance: high-interest loans that provide cash on demand, to be paid back when the borrower’s paycheck arrives. According to Mullainathan and Shafir, in 2006, there were more than 23,000 payday lender branches in the United States— more than all the McDonald’s (12,000) and Starbucks (nearly 9,000) locations combined. It’s a popular way to get money today, particularly for those without bank accounts. But for people without reliable incomes, debts must often roll over into the following month, incurring exorbitant fees. “This type of high-risk borrowing seems ridiculous,” Mullainathan says, but “we wanted to prove that thinking like this doesn’t come from a lack of financial understanding or foolishness—it comes from putting out fires.”
Mullainathan conducted a non-financial experiment that proved his point:
In 2011, in collaboration with Anuj Shah, now assistant professor of behavioral science at the University of Chicago Booth School of Business (then a graduate student at Princeton), they devised a study that they hoped would prove their point, inducing that same high-risk borrowing behavior in Princeton undergraduates by having them play a version of the American TV game show Family Feud.

In the show, contestants are asked to name things that belong to categories—for instance, “Things you might find in a professor’s office.” Unlike regular trivia games that have right and wrong answers, there are no right responses in Family Feud, just popular ones (the list of answers is gathered from a survey of 100 people prior to the show). Because contestants must think through an array of options before answering, time pressure limits the number of paths they can explore before hazarding a guess, so scarcity’s effects are in full bloom.

At Princeton, contestants were randomly split into “rich” and “poor” groups—the rich having more time to guess than the poor. All were given the option to borrow time: each additional second borrowed would cost them two seconds of “interest” deducted from their total time.

“The results mimicked everything we see in the real world,” Mullainathan reports. At first, the poor performed better than the rich did; scarcity made them focus more intently on the task. But when, in the next round, the subjects were allowed to roll over their loans and “repay” in subsequent rounds (thus making future rounds shorter), things quickly fell apart for the poor contestants. Early borrowing created a vicious circle for the poor; pressed for time, they needed to borrow more seconds, and borrowing more made them more pressed for time. By the final rounds, most of their time went to paying back loans, and the poor lost rounds that the rich won handily.

These students were randomly assigned to “poverty,” Mullainathan explains, so there could be nothing substantially different between them and those fellow students labeled “rich.” “The study shows the intimate link between success and failure under scarcity,” he and Shafir write in Scarcity. And scarcity, no matter whom it menaces, inevitably leads to more scarcity.

Greece as an example of poverty
That got me to thinking. The Greek economy has not only tanked, its growth rate parallels that of the American experience during the Great Depression (via Quartz).
That collapse in economic output puts the Greek recession right up there with the worst depressions in recent memory. At its trough in the first quarter of 2014—which was revised lower in today’s report—the decline in Greek GDP was roughly 33% from the peak. That’s actually worse than the US peak-to-trough GDP decline of 27% between 1929 and 1933, during the most acute phase of the Great Depression.

A simple analysis of the numbers doesn't convey the depth of economic depression. Consider these anecdotal accounts of what`s happening in Greece by Sky News economics editor Ed Conway:
The moment the people of Lamia realised things had really hit rock bottom was when the firemen started turning up on their doorsteps.

They went from house to house through the small, sleepy town about 200km north of Athens, knocking on doors and asking for contributions. The brigade’s funding has fallen so far that they now have little option but to go begging for cash.

Some households gave them a few pennies. Some donated odds and ends from their homes. Some even gave them new tyres for their trucks, which had been worn down to destruction. The police have been doing something similar for some time.
And there's this:
It is hard to get a sense of the scale until you look deep into the numbers. Consider the budget for hospitals across the country. In the first four months of last year, they received funding of €670m. In the first four months of this year they received €43m. That’s right: a 94% cut, which makes any austerity you’ve seen elsewhere around the world look piddling.

The director of the Elpis Hospital, Theodoros Giannaros, lost his own son to suicide two weeks ago.

He described how the country had hit "rock bottom".

"People are dying", he added.
His observations are nothing short of astounding:
I’ve been in developing countries facing fiscal and capital market crises. But I've never been in a developed economy like this as it literally runs out of money.

I've never been to a hospital where the director says he is essentially having to treat patients with no money, where people are not able to get treatments because they, and the hospital, can’t afford them.

It is an unsettling experience - made more so by the fact that even those in authority seem next-to-clueless about what is really happening.

Usually when you're covering economics or politics you assume that someone, somewhere knows what's going on and has a plan. Here, with the best will in the world, I simply don’t think there is one.
Could an entire country that is going through an economic depression make its leaders behave and bargain in an "irrational" way, or in a way that is contrary to "normal" behavior?

That seems to be the current position of the Syriza dominated government in Athens, which is: "We are hurting so much that we want the most short-term expedient way to make the pain go away, regardless of the cost."

The interpretation of Alex Andreou of the current round of negotiations between Greece and its creditors is highly revealing. Though what Andreou says has to be taken with a grain of salt as he is highly sympathetic to the Syriza position, the EU-IMF negotiation strategies may need to be reviewed in light of the Mullainathan analytical framework. First and foremost, each side is so focused on its own priorities that it is becoming blind to the other side's needs. Andreou described the EU position this way:
The entrenched position of the players has to do with domestic rather than international policies. The battle between Merkel and Schäuble behind the scenes for leadership of their party before the next German election; the threat Rajoy faces in Spain from Podemos, underlined by recent municipal results; resistance to Dijsselbloem’s programme of ultra-right-wing economic policies in the Netherlands within his own Labour Party; the failure of Renzi to stimulate a stagnating Italian economy; – all these factors, and many besides, play a much bigger part in shaping players’ position towards the Greek crisis, than anything to do with the Greek crisis.
Viewed in this context, the Yanis Varoufakis Project Syndicate essay that pleaded for growth over strangling austerity is similarly tone-deaf to the priorities of Merkel et al.

As well, the creditor institutions should not behave as if Tsipras is just another typical European leader who wants to maintain the status quo:
There was a catastrophically widely held belief among the European establishment that, once elected, Tsipras would “play ball”. There is still palpable shock at his sticking to his election commitments, often expressed as the accusation that he is being unreasonable. Every statement out of EU institutions for the last five months has been practically underlined by the subtext “shit, he wasn’t bluffing”.
Things are so bad (at least for the typical Syriza supporter) that their sensibilities are dulled by threats of dire consequences:
After living on the brink of disaster for so many years, I sense a que-sera-sera attitude in most people. This is not to say they don’t fear capital controls, the threat of Grexit, austerity, hunger, poverty and degradation. It is to say that they have lived with them for so long, they have become an ordinary part of the landscape.
In a separate article, Andreou explained why he voted for Syriza and the reasons sound remarkably like how Mullainathan described how the value system of people who are forced into poverty changes:
Syriza’s supporters were accused of being irrational, were threatened and cajoled not to destroy the country in advertising campaigns of breathtaking negativity. This confirmed in my mind that conventional politics supported the very system that collapsed globally and spectacularly only a few years ago; a system that eschews taxation, but required unprecedented bailouts from taxation; a system that, somehow, has now gone back to being considered infallible, supreme and self-correcting.

I concluded that voting for that would be irrational and that trying something different with Syriza, however risky, made better sense. Dignity might be an abstract concept, but its absence is a very real and practical thing. Stand outside a central Athens supermarket at closing time, to see elderly women, dressed in black, rummaging through bins for food and you will see it. Spend a day with my mother, who worked two jobs for 45 years, paid every cent of tax and now finds herself diagnosed with Alzheimer’s, with no decent health or social provision and a monthly pension of €400 (£300), and she will explain it to you.

Added to this, Syriza gave me a way to voice dissatisfaction with the EU without aiming to dismantle it. To ask for radical change without victimising migrants. As a migrant myself, this was very important to me. It was possible to be pro-EU and still want to punch its current monetarist policies in the face. The EU as a project is very worthwhile. We need to fight for the Europe we want. The idea that what stands between each of us and a life of prosperity is a hypothetical Romanian cleaner is the most ludicrous one we have ever been sold.
In particular pay attention Andreou's comment about ”bringing back dignity” without discussion of the costs, or what is possible under the current circumstances:
The only promise Tsipras made that truly mattered to me was to “give dignity back to the people”. Of course, he cannot deliver that. Only people can deliver that for themselves. But even mention of that word, “dignity”, in a political context, struck an important chord. It was hugely refreshing to have someone speaking that sort of language, instead of tired neoliberal dogma of privatisation equalling efficiency. To start from priorities and then define the method.
The latest polls indicate that Syriza`s popularity has soared since the last election. If an election were to be held today, it would gain a majority and be able to govern without a coalition partner (via Ekathimerini):
According to the poll by Metron Analysis, if elections were held now, 45 percent of Greeks would vote for SYRIZA and 21.4 percent for ND. Such a result would allow SYRIZA, which co-governs with the right-wing Independent Greeks, to rule autonomously. Potami garnered 6.1 percent, followed by Golden Dawn on 4.4 percent, the Communist Party with 4.3 percent, ANEL with 3.2 percent and PASOK falling below the 3 percent threshold to enter Parliament with 2.9 percent. The survey found that 79 percent of Greeks want to stay in the eurozone.
If this is indeed the mood in Athens, then it may be time to pay attention to Mullainathan's work about what motivates the Greeks. Otherwise, each side winds up talking at each other instead of with each other and the entire project goes over a cliff. Leonid Bershidsky put it another way when he said that Greece and its creditors need marriage counselling.

That sounds about right. If I am right in my analytical framework, then the current market-based estimated probability of a Greek default of 38-40% before year-end may be too low (see data and links from Bears wake up, but they're not out of the woods).


Roy K. said...

Cam- I think your post is spot on. I can also relate it to your previous post noting that poor people don't seem to plan for the future. My thought on that one is that they don't plan because they don't have the means to carry out plans ($$) and have learned from experience that it doesn't bear fruit. Planning and 'rational' thinking are characteristics of people who are able to control their lives to a large degree, a luxury that many people do not experience.

I grew up in a single-parent household but was fortunate to earn scholarships that helped me earn my way through a quality university. I am retired now and reflecting back I can see that my thinking has changed from relatively short-term when I was younger to much longer, even multi-generational now. Some of this is obviously just experience that comes with age but I believe that much of it is due to financial security. It is hard to plan 'rationally' when you don't know where the grocery money is going to come from!

Roy K.

Anonymous said...

Stressful economic situations do not create economic foolishness, they reveal it. A declining stock market conveys the same traits to fore. For many, the most difficult economic skill to master is living below your means -- certainly a lesson not learned by any federal government on the planet.