Heads I win, Tails it’s chance

Il Saggiatore has just released the Italian version of Mervyn King‘s last book, The End of Alchemy: Money, Banking and the Future of the Global Economy, which he presented last week in Milan, at the presence of professor Luca Fantacci – co-author of a book with similar title and spirit (The End of Finance, 2011).

While discussing the causes of the Great Recession, the former Governor of the Bank of England focused – among other things – on the incentives used by banks to remunerate managers and traders:

Simply anchoring pay to revenues sends a wrong message. Revenues depend on prices, and prices are determined by the system, not by a trader’s ability. In other markets this doesn’t happen. A car company, for example, will give you a bonus only if you bring people to buy your company’s cars, not others’, only if you are able to direct the demand towards your particular products. You are responsible for your own share within the market, you are not rewarded just for the growth of the entire market.”

Without analyzing the causes of the Great Crisis – although there is still a vivid debate on King’s responsibilities (see here, here, here, and here), together with Gordon Brown’s faults (see here, here, and here) –, we should note that King’s statement is implicitly based on an hypothesis: people should be rewarded (only) for their merits. Not a strong one, after all. People commonly think that a pay is “fair” if it is in line with the contribution given to a certain enterprise or activity. However, as usual, the issue is not that simple, for two important problems seem to be overlooked.

Firstly, interaction. For many, economics focus on two different and partly independent aspects: producing and distributing wealth. As in classical economics, the economic problem is split in two steps: first we think at producing goods and services – we “bake the cake”, as large as possible, i.e. we deal with growth –, then we think at dividing the revenues among us – we “cut the cake in slices”, according to the contributions given, i.e. we deal with equality. In this view, strongly influenced by micro/entrepreneurial mechanisms, the two stages are separated and well-distinguishable. However, while this is probably true for businesses and the like – where the two processes involve different actors, usually –, this does not hold in general, from a macroscopic perspective. In particular, not only growth dynamics influence distributional dynamics, but also equality impacts production, in a sort of recursive mechanism.

Secondly – and more importantly –, there is a quantitative problem, an issue of measurement: How do we measure our contributions? How do we assess our merits? How do we “cut the cake”? Are we even capable of evaluating contributions fairly?

All these questions deal with what in psychology is called attribution i.e. the way in which humans explain the link between causing behaviors and consequent events – and motivate the (tentative) research proposal that you can find briefly explained here.

In general, those behavioral studies that have hitherto investigated the subject state that people’s attributions are strongly biased, especially when involving themselves. In particular, humans are affected by the so-called self-attribution bias, a cognitive phenomenon by which people tend to attribute success to innate aspects such as talent and foresight, and attribute failures to situational factors. In other words, people use merit to describe success, and excuses to justify failures. Or, as Langer puts it: “Heads I win, Tails it’s chance”.

More specifically, under the umbrella of self-attribution bias fall (1) people’s tendency to attribute their successes to internal factors and their failures to external ones (self-serving bias), (2) the fact that, when making attributions about another person’s actions, individuals overemphasize the role of dispositional factors, while minimizing the influence of situational factors (fundamental attribution error), and (3) our tendency to undervalue dispositional explanations and overvalue situational explanations of our own behavior (actor-observer bias).

But how does the bias work? As said, we have a tendency to claim an irrational degree of credit for success (self-enhancing bias) and to irrationally deny responsibility for failure (self-protecting bias). This is due both to cognition – individuals have limited information processing capacity – and to motivation – people want to maintain their self-esteem and feel good about themselves. So, on the one hand, we are moved by our will to protect our self-esteem by creating causal explanations (self-enhancement), on the other, instead, we want to convey a desired image to others (self-presentation). Overconfidence is the main channel through which the bias acts, leading people to estimate their performances, achievements, and forecasts.

The role of the self-attribution bias has been explored in many non-economic fields such as education, politics, anthropology, and sports (the famous “hot hand fallacy”) – «as any cognitive perception, self-attribution bias embraces almost every aspect of human behaviour and action, even love» (cit.)but, given our premises, it is crucial to take it into account when analyzing economic behavior.

Behavioral finance studies have shown that attribution bias may lead to overtrading, and that it brings not only individuals, but also markets to become more overconfident when returns have been high.

Corporate management studies, in turn, link it to the Hubris Theory of M&A, indicating that managers tend to persist in their behavior despite economic opportunities, and find also that biased managers are more likely to issue forward-looking statements and make optimistic forecasts.

But, more importantly:

Welfare and public economics conclude that:

  • Attributions affect the judgements regarding social justice, inequality, meritocracy, and welfare distribution (see here);
  • Biased attributions affect people’s willingness to redistribute goods and resources (see here).

The newborn (and longed-for, see here and here) field of crisis economics has established a strong link between biased attributions and speculative bubbles:

  • The 2013 Nobel Prize Robert Shiller, one of the fathers of behavioral finance, argues that financial markets can be “irrationally exuberant”, and that during investment, production, and financial bubbles people are excessively self-attributing, while during downturns “it’s someone else’s fault”;
  • Roubini and Mihm indicate self-attribution bias as one of the factors untethering prices from any rational basis, letting them spiralling skyward until they can go no higher, and then crashing in an equally irrational way, dropping far below what’s justified: “Investors in a speculative bubble attribute their growing profits not to the fact that they and thousands of other equally deluded fools are participating in a bubble, but to their own perspicacity” (see also here).

In sum, Lord King certainly got it right: wrong incentives can play a central role, especially if they amplify the distortions that are already in our mindset. But if, on the one hand, attributions can threaten the so-called “well-functioning” of the market (fostering cyclical and systemic crises, for instance), we might need to make a further step forward.

The results proceeding from attribution theory can severely jeopardize the idea of “meritocracy” (see here), of a society in which the identification of merits and responsibilities is the basis of social relationships. Any justification of behavior (of unequal gains, for instance) relying on the hypothesis that people can discriminate, that the system can objectively and independently reward agents despite of arbitrary judgments, in fact, is deprived of its anthropological and psychological premises, and therefore must be rejected.

In a world in which attributions are biased, systematically mistaken, no social foundation can be laid on the basis of pure merit, which can prove a useless abstraction. And while responsibilities and merits, being an essential part of our idea of justice, cannot be completely left aside, we will still need to rely on alternative grounds to organize ourselves.

Featured image: Giovanni Battista Tiepolo, Allegory of Merit Accompanied by Nobility and Virtue (1758)


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