We're Not as Smart as We Think

Why We're Stuck, Part 2

Last week I described my concern about the absolutist perspectives that characterize both political parties. If you agree with them, you are intellectually right and morally good; if not, you are both wrong and evil. These polarizing stances have put a new kind of strain on freedom of expression, with coercion supplanting persuasion as a political tool. Incremental change through compromise is disdained; each party interprets tiny majorities as a mandate for sweeping change.

I made the statement, “sweeping change almost always produces bad outcomes,” based on 45 years of observing national politics, particularly economic policy, as practiced by administrations with very different priorities. There is always the problem that political decisions involve a tangle of motives, some of them corrupt; not to mention influences, some of them corrupting. But the more fundamental problem is that we overestimate our ability to understand both what is happening and how to change the trajectory of events.

Friedrich Hayek wrote a seminal article for the American Economic Review in 1945, “The Use of Knowledge in Society,” that offers an explanation. The catalyst for the article was a proposal for a Central Pricing Board to supervise economic management for postwar British governments. Hayek argued that centralized economic planning could never match the efficiency of markets because what can be known by a single group of people, no matter how knowledgeable, comprises only a tiny fraction of the sum of knowledge held by the members of society. Markets enable this dispersed knowledge to come into play as millions of people buy and sell. A planning board cannot replicate this activity; it must create models that crudely approximate market activity.

Hayek distinguished between local, practical knowledge and theoretical knowledge. We prize theory highly but tend to be dismissive of the detailed knowledge that comprises most of daily life. Architecture is an esteemed profession, but the knowledge of carpenters, masons, plumbers, and electricians is respected less highly. There wouldn’t be many houses built without them, though. And I’ve been close enough to the practice of architecture over the years to have seen brilliant architects produce intriguing designs that have resulted in utterly dysfunctional buildings.

It may seem an exaggeration to dismiss the sophisticated economic modeling of our day as a crude approximation. Economic modeling has advanced significantly since Hayek’s day, utilizing computational ability beyond the dreams of 20^th century economists.

And yet, crude approximations our models continue to be. I’ve lost count of how many recessions have been forecasted in the past five years. They are constantly just around the corner. How many economists forecasted the inflation of 2021 and 2022 – other than the economists who have been forecasting inflation every year for the past two decades?

One problem is that big data, no matter how much you have, is part of the past by the time you obtain it. And yet, our concern is always about the future. Our ability to perform complex analysis has produced an assumption of precision that is wildly at odds with reality.

A second problem is that all models incorporate simplifying assumptions. All theory rests on such assumptions. Though we take them for granted, they are not infallible. Daniel Kahneman was awarded a Nobel Prize in Economics for showing that a bedrock assumption of economic theory – that economic decision-makers are rational – was not tenable.

Ironically, economic modeling can achieve great accuracy at what we might call the local level – microeconomics, also known as pricing theory. But a full understanding of the macro economy, which is what we yearn to understand, continues to elude us.

Kahneman’s work is often deemed to show that decision-makers are irrational, and yet this is not the case either. It’s more accurate to say that his work demonstrates the people are not quite rational; and in fact, they tend to be less than rational in consistent ways.

Photo by Marga Santoso on Unsplash

Has it ever occurred to you that we live in a world that is not quite logical? It is never completely illogical; there is always evidence of design. And yet, events repeatedly play out in a way that can entrap unwary logicians.

When we pursue sweeping change at the national level, we ignore the objections of roughly half the community. All of us have gaps in our knowledge; we make assumptions that reflect a flawed understanding of reality, or distorted values, or maybe both. Our neighbors have some of the knowledge we need, and we ignore it at our peril.

I’m tempted to make the point here that some sweeping changes are less fraught with risk than others – those that loosen restrictions rather than tighten them. But that reflects a value proposition – that better economic efficiency is worth the price of negative impact on a segment of the community. I think I’m right about that! But so does the person who disagrees with me.

Warren Buffett is stepping down after an extraordinary 60-year run as CEO of Berkshire Hathaway, a tenure that has built his reputation as the outstanding investor of our time. I’ve read his annual reports for 25 years. What strikes me is not his brilliance but the modesty of his thinking. Successful investing is intellectually easy but emotionally difficult. Market activity will always prompt an investor to do the wrong thing. We want to buy when stock prices are going up, everyone seems to be making money, and optimism reigns; we want to sell when prospects seem dim. This results in buying at high prices and selling at low prices – the opposite of what an investor should do. Buffett’s simple prescription: invest for the long term in something you understand and ignore the market’s fluctuations.

I am not making a pollyannish plea for everyone to just get along. My point is purely pragmatic: we make better decisions when we have appropriate modesty about the limits of our knowledge, and when we open-mindedly seek to learn more. Warren Buffett’s career shows that modesty, about what you can know and about your own ability to manage your emotional response to events, is the key to investment success. It’s the key to success in other realms, too. Would that more leaders, making decisions that affect all of us, adopted that perspective.