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Explaining Fiscal Foolishness—Psychology and the Economy

A behavioral scientist discusses the irrational human impulses that led to the economic downturn

Peter A. Ubel is professor of medicine and psychology at the University of Michigan at Ann Arbor, where he explores the quirks in human nature that influence our health, happiness and society. He is author of the book Free Market Madness (Harvard Business School Press, 2009), which investigates the irrational tics that lead people to overbid on eBay, eat too much ice cream and take out mortgages they cannot afford. In an interview with Jonah Lehrer, Ubel explains how innate optimism, greed and ignorance can depress financial and physical well-being—and how individuals can commit to change.

Scientific American Mind: Your new book, Free Market Madness, argues that conventional economics, which assumes that humans are rational agents acting in their own self-interest, is deeply naive and scientifically unrealistic. Instead you describe a brain brimming with biases and flaws. Do you think these flaws are responsible for the latest economic turmoil? If so, how?

Peter Ubel: Irrationality is responsible for the economic mess we find ourselves in
right now—irrationality plus greed, of course, and a sub­stan­tial dose of ignorance. Let us start with ignorance. I am sad to say that many Americans have a difficult time with even simple math—around a third of American adults cannot calculate 10 percent of 1,000. People who struggle with concepts such as percents have an extremely difficult time with more complicated ideas, such as compounding of savings and, very relevant to our cur­rent crisis, adjustable-rate mortgages.

To make matters worse, most of us are hardwired for optimism. Ask us how we rate as drivers, and the vast majority of us are convinced we are above average—even those of us who have gotten into multiple car accidents. As a result of our unrealistic optimism, we are convinced that our incomes will rise fast enough to keep up with our outsized mortgage, or that our adjustable rate will not rise, or that our house’s value will indefinitely outpace inflation. We are social beings, too, and frequently judge our own decisions by seeing what other people are doing. If my neighbor added on a new kitchen with a home equity loan, I might assume that is a good idea for me, even if a more rational weighing of my finances would suggest otherwise. Even savvy financiers can get caught up in irrational impulses. If a competitor’s firm makes huge profits on risky loans, it is easy for me to push aside my fears about such risks: if he took those risks and was rewarded, maybe I overestimated the risks!

Mind: What can eBay teach us about human irrationality?

Ubel: eBay auctions help to reveal the rational and irrational forces driving consumer behavior. People are often quite rational, after all. Raise the price of a T-shirt, and generally, fewer people will buy it. Reduce the quality of a good, and you better reduce its price, too! But behavioral economists have analyzed eBay data to help identify some ways that consumers act irrationally. [For more on eBay and irrationality, see “Is Greed Good?” by Christoph Uhlhaas; Scientific American Mind, August/September 2007.] Offer a really low price for opening bids, a price everyone knows will not be the final selling price, and you nonetheless lure some consumers into making an initial bid. That increases the number of people bidding on the product, which makes it look more attractive, thereby generating even more bids. And then bidders, who knew the price would rise from their initial bids, get emotionally attached to the product and keep raising their offers. Now you know why it makes sense to tell people that bids for that Picasso hanging in your living room can start at $5!

Mind: You also argue that by taking our own irrationality into account, we can improve our health and well-being. Can you provide an example of a way to achieve such improvement?

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