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Economics = psychology, sociology + a whole lot more

Humans are driven by psychological processes and group dynamics. Accordingly, processes are driven not only by reason, but also by emotions. Financial institutions need to accept that this is our nature and tailor their decisions to that fact.

Proclaiming this insight is the main mission of Theo Kocken, Professor of Risk Management and founder of Cardano, primarily by warning investors that relying solely on mathematical statistics and models is extremely dangerous. Kocken is a big fan of mathematics and, as an econometrician, he grew up with mathematical formulas. “In fact, I think mathematics is incredibly beautiful, because you can use it to model a wide range of phenomena on earth, such as how things develop in nature. You can use it to describe the processes that we see all around us. The Fibonacci series is so beautiful that I used to get teary-eyed when I saw all the beautiful ratios it produced. When I got a job in banking, the econometrician within me still looked for ways to apply mathematics that didn’t exist yet.”

From great optimism to total collapse

During his time with ING, the discrepancy between statistical data on the surface and the real underlying processes became increasingly clear to him. “This was particularly evident in emerging markets in the mid-1990s. Everyone was full of optimism: there was no way that things could go pear-shaped. A lot of money was pumped into emerging markets, because of the low risk involved. Deep down, you could see that lots of things were going wrong, but still the banks treated these countries as if they were outperforming their western counterparts. They built up high levels of debt, developed reserve deficits and experienced higher inflation than other countries, but the models only indicated what was happening on the surface, painting a pretty picture with little volatility. My suggestions to apply more models, such as stress tests, scenario analysis and common sense, gradually lost support. Even the regulators told me ‘to stick to the mathematical models you know so well, because looking deeper and investigating other factors is far too complicated. We would have to use other techniques, which are not compatible with our standard procedures.’ I remember thinking back then that everything would go hopelessly wrong and, indeed, emerging markets collapsed completely a few years later.”

Financial institutions must accept that this is in our nature and need to know how to tailor their decisions accordingly.

It has never ceased to surprise Kocken how people keep clinging to the certainty provided by an incorrect model. “Better to be exactly wrong than roughly right, they say. It was easy to build legislation around mathematics and statistical methods, so that was all people focused on. It was an understandable move to make, to be honest. It has been a gradual process for me, too, and it took me quite some time to realise that we had to change the world. That’s when I started Cardano and when we began to focus more on extreme risks rather than taking a narrow-minded approach based on averages and the minor degree of uncertainty that surrounded them.

According to Kocken, our world is so fundamentally uncertain because human behaviour is not just based on rational decisions, but also – and importantly – on emotions. “Of course, that’s also a good thing. Group dynamics and psychological processes are enormous drivers for us: people react to each other, setting processes in motion that are not necessarily driven by reason, but also by emotions. We can be very rational at times, such as when we have to decide between buying bread or meat. In elections, though, or when we buy a house or shares, we can be influenced by what others do and change our behaviour, leading to collective irrationality. This, in turn, is what creates times of euphoria and bubbles. Again, these phenomena are not necessarily bad, but it is important that society learns how to deal with them. Financial institutions must accept that this is in our nature and need to know how to tailor their decisions accordingly.”

Emotion-driven assumptions

One way to do this is to simulate a set of plausible, yet unlikely scenarios, “to test what you would do if such a scenario were to occur. If you can run these simulations, you’ll have a tool that lets you respond to new developments a lot more quickly. Instead, we insist on clinging to models based on emotion-driven assumptions, but when we use the models, we follow the premise that humans are rational, unchanging and uninfluencable. The output of the models is finally translated into government, investment and risk policy. It all seems very safe, but in fact, it instils a totally false sense of security.”

Kocken believes there are several reasons that those conventional models are still used today. “Models feel safe and eliminate a lot of uncertainty. Combine a little bit of maths with a dash of statistics and you’re left with a clear path forwards. In the event that a long-term process ultimately fails, like in politics or the financial markets, you can blame bad luck instead of stupidity. This approach greatly reduces the speed of learning processes, compared to, say, how we respond to plane crashes. The aviation industry has much better learning processes as pilots imagine what else could go wrong and improve safety measures accordingly. We don’t have those processes in the world of finance.”

If you were to incorporate debt in the models, you would see that we’re in a truly perilous situation.

Kocken believes that another reason why we refuse to get rid of the models we have been using for the past 50 years is that there are currently no comprehensive alternatives. “People want a simple, unified model, but the uncertainty of reality dictates that you have to use a range of different models and techniques.  What you need is a multidisciplinary approach, integrating psychology, sociology, history, mathematics, physics, anthropology and complexity theory, as well as involving issues such as urbanisation and demographic and technological development. Only then can you set out on the long journey to greater adaptivity, and that doesn’t sound comfortable at all.”

Kocken predicts that it could take another twenty to thirty years before we abandon the old paradigms about how the world works. “If we ever want to progress from the rational model to the real world, we have to start educating people in secondary school, and maybe even earlier. We have to explain that we know a lot less than we think we do, and that a large part of economics boils down to sociology and psychology. We need to teach people to work with different tools and models from an early age. Only then will the new way of thinking replace the old paradigm.”

Trying something new hurts

Kocken believes that the financial world does actually know that its traditional models don’t work and that a new approach is needed. “The old methods may feel safe, but financial institutions are gradually warming to the new way of thinking. They can’t, however, let go of the old approach yet, so they stick to the course and try to cram in some of the new, which, ultimately, is an attempt to consolidate two incompatible systems. That’s the point we are at now and I understand why. Most people grew up with the old methods and respect the status quo; it was developed by Nobel laureates, after all, so there must be some truth to it. If you ask those very Nobel laureates, though, they’ll tell you that they merely developed a concept that was later taken completely out of context. Now, people are afraid to let go of what they grew up with.”

Anyone asking a question about the economy is essentially asking for a prediction, says Kocken. “The best economists say, ‘I don’t know’, which makes people very insecure, as they find it very uncomfortable to admit that we actually know very little. What we can do is think about which situations could develop and how you would respond. It’s annoying to see people using models that have little added value at best and may even be counterproductive at worst. The simple fact is that trying something new hurts if you’ve been comfortable for ages. Moreover, it’s easy to hide behind the fact that ‘everyone does it this way’.”

There’s nothing more the financial authorities can do to give the economy another shot of morphine.

That’s why we continue to live with a false sense of security from one day to the next, Kocken argues. “Economic bubbles are created by euphoria and by the conviction that other people know what they are doing. The same process occurs in the science of economics. Sometimes, economists do things that they should have known would turn out for the worse. For example, we’re euphoric about today’s economy again, even though it’s still full of debt, which we conveniently choose to ignore. None of that debt is accounted for in the mathematical models, after all, even though debt levels are higher than ever before. All you can do is hope that you’re doing something useful, because if you were to incorporate debt in the models, you would see that we’re in a truly perilous situation.”

Ripping holes in the old paradigms

Kocken doesn’t consider himself a voice crying in the wilderness. “Confidence in models and the makeability of the economy peaked in the 1990s. Certain economists, such as future Nobel laurate Robert Shiller, did point out the wrong assumptions being made. That group of economists is now much larger, with more than 30% advocating a different approach. Although the old guard is still in the majority, they’re now being challenged, so you could say we’ve reached an interesting crossroads. It’s only a matter of time before the foundations propping up the old system fail, as every new crisis will rip a bigger hole in the old paradigm. The tide will turn eventually, but for that to happen, things will have to go wrong first.

Fortunately, our toolkit for dealing with uncertainty is becoming bigger day by day, with tools like Agent Based Modelling, network theory and scenario thinking. None of these tools will imbue us with predictive powers and ease all discomfort, but combining them can let us navigate uncertain waters.”

Financial amnesia sets in after seven to ten years

With a shake of his head, Kocken laments that we just won’t learn from the past. “Earlier this year, when the AEX reached its highest point in recent memory, an expert came out in the media saying that the current situation resembles the 1990s, which also saw tremendous growth. I asked myself, why is he ignoring the fact that there was virtually no debt in the 90s, whereas we now have the highest debt in the history of mankind? In the 1990s, interest rates were at 8 or 9%, whereas they’re at zero today. There’s nothing more the financial authorities can do to give the economy another shot of morphine Comparing today’s situation to the 90s just makes no sense to me. Once things have been going well for a while, we tend to forget about the past. As John Kenneth Galbraith said, Financial amnesia sets in after seven to ten years, after which you forget everything you went through. That’s the point we’re at now.”

Kocken has gradually lost all his respect for traditional economic authorities. “I’ve reached the point where I can go into all-out rebellion, which is also my main drive. Like Keynes said, when you see something’s wrong, you change your mind. If you don’t, you’re stupid. The essence of science is that you keep questioning, but much of what we call scientific knowledge is based on assumptions. We simply call in mathematics, which can’t be refuted, and call it a day. True, mathematics can’t be refuted, but the underlying assumptions can. We often forget that. Sets of assumptions often become beliefs, as you can see in economists who proclaim that we are fundamentally rational and that equilibrium exists. They simply don’t accept that their assumptions have been refuted. In economics, the highest form of knowledge is knowing what you don’t know.”