Misbehaving: The Making of Behavioral Economics (38 page)

I am not sure whether “90% of the time” is a satisfactory definition of “almost all” of the time, but more importantly, a factor of 2 strikes me as a very wide margin to call a market efficient. Just think about all the housing units built during the real estate bubble that are still worth only half of what their value was at the peak. The people who bought those homes would probably disagree with an assessment that the housing market was acting efficiently during the boom. Furthermore, Black died in 1996, before the technology and real estate bubbles. I think if he were still around he could be convinced to revise that assessment to “right within a factor of 3.” The NASDAQ index lost more than two-thirds of its value from its peak in 2000 to its trough in 2002, and the decline is almost certainly due to initial exuberance. (It can certainly not be blamed on the Internet proving to be a disappointment.)

My conclusion: the price is often wrong, and sometimes very wrong. Furthermore, when prices diverge from fundamental value by such wide margins, the misallocation of resources can be quite big. For example, in the United States, where home prices were rising at a national level, some regions experienced especially rapid price increases and historically high price-to-rental ratios. Had both homeowners and lenders been Econs, they would have noticed these warning signals and realized that a fall in home prices was becoming increasingly likely. Instead, surveys by Shiller showed that these were the regions in which expectations about the future appreciation of home prices were the most optimistic. Instead of expecting mean reversion, people were acting as if what goes up must go up even more.

Moreover, rational lenders would have made the requirements for getting a mortgage stricter under such circumstances, but just the opposite happened. Mortgages were offered with little or no down payment required, and scant attention was paid to the creditworthiness of the borrowers. These “liar loans” fueled the booms, and policy-makers took no action to intervene.

This lesson is one of the most important to take away from the research about market efficiency. If policy-makers simply take it as a matter of faith that prices are always right, they will never see any need to take preventive action. But once we grant that bubbles are possible, and the private sector appears to be feeding the frenzy, it can make sense for policy-makers to lean against the wind in some way.

Central banks around the world have had to take extraordinary measures to help economies recover from the financial crisis. The same people who complain most about these extraordinary recovery measures are also those who would object to relatively minor steps to reduce the likelihood of another catastrophe. That is simply irrational.

________________

*
   It was possible to find some shares to borrow if you had time on your hands. In fact, at the time, there was a finance PhD student at the University of Chicago who was determined to make money on 3Com/Palm. He opened accounts at every discount brokerage house and spent all of his time trying to borrow shares of Palm to sell short. Whenever he got Palm shares he would sell them short and use the proceeds to buy the number of shares of 3Com required to hedge his bet. When the deal was finalized a few months later, he made a tidy profit and bought a sports car that he nicknamed the Palm-mobile. The moral of this story is that it was possible to make tens of thousands of dollars from this anomaly, but not tens of millions.

†
   A similar situation arose in mid-2014 when Yahoo’s holdings of Alibaba were calculated to be worth more than the whole of Yahoo (Jackson, 2014; Carlson, 2014).

‡
   When I described this anomaly to the CEO of a large pension fund sometime in the 1990s, he said I must be wrong because surely the smart money would just buy whichever shares were cheaper. I said, “Really? I believe your fund owns millions of dollars of the more expensive version,” and offered to bet a fancy dinner that I was right. He wisely didn’t bet. His fund was partly indexed to the S&P 500, which then included the Dutch version that was selling at a premium.

§
   Full disclosure: Since 1998 I have been a partner in a money management firm called Fuller and Thaler Asset Management that invests in U.S. equities by finding situations where investors’ behavioral biases are likely to cause mispricing. The fact that we are still in business suggests that we have either been successful at using behavioral finance to beat the market, or have been lucky, or both.

VII.

WELCOME TO CHICAGO:
1995–PRESENT

During what amounted to a job interview at the University of Chicago for a position at what is now called the Booth School of Business, I had a lunch meeting with several of the finance faculty members. As we left the business school to walk over to the faculty club where we would have lunch, I spotted a twenty-dollar bill lying on the sidewalk, right outside the building. Naturally I picked it up, and then everyone started laughing. We were laughing because we all realized the irony of this situation. There is an old joke that says a Chicago economist would not bother to pick up a twenty-dollar bill on the sidewalk because if it were real, someone would already have snagged it. There is no such thing as a free lunch or a free twenty-dollar bill. But to a heretic like me, that twenty looked real enough to be worth bending over. 

My appointment was not without some controversy in the school. Predictably, Merton Miller was not too happy about it, even though my primary appointment would not be in finance. Instead, I would join the behavioral science group that was made up primarily of psychologists, which I viewed as a plus. I would have the opportunity to build the kind of group of behavioral scientists with strong disciplinary training that I had long thought should exist in a top business school, and while so doing, I would have a chance to learn more about psychology, a field in which my knowledge was quite narrow.

I am not privy to the internal conversations the faculty had at the time my appointment was considered, but a magazine reporter interviewed Gene Fama and Merton Miller after I arrived, wondering why they were letting a renegade like me join them. Gene, with whom I have always had a good relationship, replied that they wanted me nearby so that they could keep a close eye on me, his tongue firmly in cheek. The reporter pressed Miller a bit harder, specifically asking him why he had not blocked my appointment. This was obviously an impertinent question, to which Miller might well have replied, “None of your business.” Instead, he said that he had not blocked the appointment “because each generation has got to make its own mistakes.” Welcome to Chicago!

27

Law Schooling

I
spent the academic year 1994–95 as a visiting professor at MIT’s Sloan School of Management in order to spend some time with France Leclerc, who was then on their faculty in the marketing department. It was during that year that we both accepted faculty positions at the University of Chicago Graduate School of Business (as it was then called), and we later married.
*
While at MIT I got a call from Orley Ashenfelter—the economist who had let Eldar Shafir and me use his wine newsletter to study mental accounting—asking whether I might give a plenary talk on the applications of behavioral economics to the law at a conference he was organizing. “We need some of that wackonomics,” he said. I told Orley that the topic was definitely interesting, but I knew nothing about the field of law. I said I would look for a knowledgeable collaborator and get back to him.

One of the participants in our first summer camp, Christine Jolls, was a prime prospect. She was just finishing up both her PhD in economics at MIT and her law degree at Harvard, and was a hard worker. Christine was game, and as we tossed around topics to cover we soon came up with enough material for a decent talk, so I told Orley we would accept his invitation. The basic idea was to think about how the field of law and economics, as currently practiced, should be modified to accommodate recent findings in behavioral economics.

The traditional law and economics approach was based exclusively on models of Econs. Many of the articles took many pages to reach the conclusion that things would turn out for the best if markets were left alone to sort things out. Many of the arguments depended implicitly on some form of the invisible handwave.

Our idea was to introduce some of the essential elements of behavioral economics into such arguments and see how they would have to be modified. By this point I had adopted the pedagogical device of calling these essential elements “the three bounds”: bounded rationality, bounded willpower, and bounded self-interest. In law and economics these properties of Humans had heretofore been assumed to be thoroughly unbounded.

I ended up having to miss the conference, leaving Christine to give the talk solo, but it went over well enough that we thought it was worth expanding into an academic paper. We planned to get busy on that once we both settled into our new jobs. She had been hired by Harvard Law School and would join their faculty at the same time that I was arriving at Chicago.

The stars must have been in some kind of fortuitous alignment, because when I arrived at Chicago, the first faculty member I met from outside the business school was Cass Sunstein, a professor at the law school. Cass had already been collaborating with Danny and was excited about behavioral economics. In the world of academic law, Cass is a rock star. Although nominally his specialty is constitutional law, he has written articles and books on nearly every branch of the law, and is widely admired. We had lunch a couple times and hit it off well. His enthusiasm is catching, and his encyclopedic knowledge is astonishing. At some point I suggested to Christine that we should consider asking Cass to join our behavioral law and economics project. It was not a hard sell. Adding Cass to your research team is a bit like adding Lionel Messi to your pick-up soccer game. Soon we were off and running. And I mean running, because Cass is fast.

It took only a few months for the three of us to produce a draft of a paper that we titled “A Behavioral Approach to Law and Economics.” It was the longest paper I have ever written. To law professors, the longer a paper is, the better, and there can never be too many footnotes. The published version of the paper came in at 76 pages and 220 footnotes, and it was only this short because I kept complaining of its excessive length.

When we had a draft ready to submit for publication, I learned that the process is very different in legal circles than in economics. In economics, you are only allowed to submit your article to one journal at a time. If they reject it, you can try another one. But law reviews allow authors to submit to several at once, which we did. The
Stanford Law Review
was the first to get back to us with an acceptance, and soon after another law review was expressing interest as well. We had bargaining power, so I made a suggestion. Since the editors were so keen to get this article, and it was bound to be controversial, why not get them to solicit a commentary from a prominent representative of the law and economics inner circle to be published in the same issue, with us having the opportunity to reply? I had in mind how the debate with Merton Miller and his team had attracted a lot of attention to the closed-end funds paper, and I thought this might have a similar effect.

The obvious choice to provide the critical commentary was the legal scholar Richard Posner. Posner is considered by many to be the founder of modern law and economics, and he has written the definitive treatise on the subject, revised numerous times. The field Posner helped create introduced formal economic reasoning into legal scholarship. From the beginning, law and economics was primarily based on traditional, Chicago-style economics, so he had a considerable investment in the approach to which we were offering an alternative.

We knew that Posner would find much to criticize in our approach, and we also knew that he could knock off a comment quickly. In spite of his serving both as a part-time law professor and federal judge on the Seventh Circuit in Chicago (one step below the Supreme Court), his research productivity is legendary. As the economist Robert Solow so colorfully put it: “Posner evidently writes the way other men breathe.” Writing a comment on our long article would not take him much time.

Although we had a good hunch about what Posner might think of our paper, any uncertainty about which parts of the paper he would find to be most objectionable was resolved the day before the three of us were to present our paper at the University of Chicago Law School. That morning we received a letter from him with his comments. The letter, which ran many single-spaced pages, was highly critical, and quite emotional. Posner told us he had written up his thoughts so that he could remain silent during our talk, knowing that others would be anxious to speak as well. Maybe he thought it would serve as a good commitment strategy.

Before getting to what the arguments were about, some background is required. When Richard Posner and others of his generation started the law and economics movement, there were many legal scholars who were uncomfortable with some of the conclusions of their work, but they lacked the economic training to put up a good fight. At that time, the few law professors that had any formal training in economics were using the traditional approach based on models of Econs, and legal scholars who tried to challenge the conclusions of such papers often felt bullied if they entered the ring against the law and econ crowd, who could brush aside critiques with a condescending “Well, you just don’t understand.” As a result, at our workshop some attendees would be defending the old-time religion, like Posner, while others might be (quietly) rooting for the underdogs to score some points against the bullies.

Cass and Christine both thought I should present the paper. They argued that I had more battle experience, or at least that was their story. They were nearby, and I kept expecting to look over at them and find them hiding under the table.