Cognitive dissonance in politics, markets and monetary policy

For a while I have wanted to write something about what psychologists call “cognitive dissonance”. The way I think about cognitive dissonance is that individuals tend to look for confirmation of their already held views.

To give an example imagine that I think that all Muslims are potential terrorists (I do not think so…) then I would take any news story about war or terror in the Middle East as confirmation of this bias, while I would tend to ignore all other information. That would be cognitive dissonance.

Politics and cognitive dissonance – partners in crime

It seems to me that cognitive dissonance is very common in political discussions. Just take a look at your Facebook feed. Your libertarian FB friends will put out stories about police brutality to show that the government’s use of unlawful violence is widespread. Your socialist friends will put out stories about the evils of multi-national corporations that exploit Chinese workers and your conservative friends will put out stories about immigrants who have committed crimes.

I am not a saint. I do exactly the same thing. I tend to read news stories, which tend to confirm my views rather than challenge my views. That is just how it is, but I am also fairly aware that this is how it is, while I think most people don’t really think much about it.

The reason cognitive dissonance is so widespread in the world of public political “thinking” in my view is that the individual cost of cognitive dissonance is very small. For the average Dane the cost of thinking that “all Muslims are terrorists” or that “all Romanians are criminals” is very small. You get some utility from having an idiotic view and you also get some utility spreading it to your Facebook friends who have similarly idiotic ideas and “likes” what you write, but you don’t feel an urge to spread views that might challenge your own and your friends biases. Somebody might tell you that you are an idiot for believing in gravity.

Rational politicians will happily play along. After all it would be rather costly for the average politician to speak out against the average voter’s wrongful biases. Voters normally don’t tend to vote for people who tell them that they are wrong.

This is of course a variation of Bryan Caplan’s rational irrational voter. What Bryan has argued in a number of papers and in his great book The Myth of the Rational Voter is that the cost for the individual voter of having wrongful biases is small. As a result voters for example tend to be nationalistic and protectionist, while economists tend to be “cosmopolitarians” and pro-Free Trade.

Markets make cognitive dissonance very costly

Imagine on the other hand a situation where having cognitive dissonance will be very costly to you. Lets say you are convinced that you can fly. That conviction can be deadly – I am on the top of the Empire State building. There is a queue to the lift. Why wait? I can just jump out from a window and fly down. And now you are dead…

I guess there is natural selection here – people who don’t believe in gravity or think they can fly end up killing themselves, while those us who understand basic physics tend to live a bit longer.

This is exactly how markets are dealing with cognitive dissonance. Lets take the example of financial markets.

Anybody who have spend a bit of time on a trading floor will tell you about the typical trader – the homo tradicus. The only thing important for the homo tradicus is his P/L – his profit and loss. His P/L on a second-by-second basis also tells him whether his view of the world – this trading position – is right or wrong. This tends to strongly reduce cognitive dissonance – suffering from cognitive dissonance would fast wipe out the homo tradicus.

This is likely also the reason why many traders seem so horribly (but rationally) “inconsistent” when you talk to them. It is very common than when you talk to a trader he will tell you how successful he has been buying dollars and then two days later he will tell you that he has been a seller of dollars all along. A successful trader will never fall in love with a certain position and he will know when to cut a loss.

A successful trader would follow Keynes’ dictum “When the fact change. I change my mind”.

This I in general believe goes for markets – markets will force economic agents to be unbiased contrary to in politics where cognitive dissonance actually seems to make you more successful.

Monetary policy and cognitive dissonance

I believe that cognitive dissonance also is highly relevant for the decision making process in monetary policy. Just take the concepts hawks and doves. A hawk (dove) is a monetary policy maker who in general believe that monetary policy should be tighter (easier).

But does it make any sense always or nearly always being in favour of a tighter or easier monetary policy? If on average the central bank hits its target over time then logically half of the time monetary policy needs to be tightened (eased), which would warrant monetary policy makers to be hawkish (dovish).

However, observing central bankers it is pretty clear that they tend to be very biased. Just take somebody like Dallas Fed president Richard Fischer. Since 2008 he has been consistently hawkish. As inflation (and inflation expectations) has more or less consistently been below 2% and unemployment has been high we today know that Fisher’s hawkish stance has been wrong. Had he been a trader he would probably long ago had been without a job.

Interestingly enough back in 2008-10 Fischer was warning about inflationary risks from Fed’s policies. Today Fisher is warning about bubbles. He has maintained his hawkishness, but changed the reasons for being hawkish. That to me is a very clear indication that Fisher is suffering from serious problems with cognitive dissonance.

Fisher is not unusual. In fact I believe that Fischer is a pretty “normal” central banker. Most of them suffers from cognitive dissonance exactly because the individual cost for them of being wrong is very low.

Dealing with cognitive dissonance in monetary policy making

There is numerous ways of reducing cognitive dissonance in monetary policy making.

The obvious possibility is simply to take away central bankers’ discretionary powers and instead leaving the implementation of monetary policy to the markets. This would essentially be what we would have if the central bank for example implemented monetary policy by “pegging” market expectations for inflation or nominal GDP growth as suggested by Robert Hetzel and Scott Sumner.

A slightly less revolutionary suggestion could let “good forecasters” have more votes in the monetary policy making body. Lets take the Fed’s FOMC. Here the members could be asked to make forecasts on the Fed’s two more or less explicit targets – unemployment and core inflation.

Then on a rolling six or twelve months basis each FOMC member would be ranked based on their “forecasting accuracy”. The two worst forecasters would then loose their vote on the FOMC for a period of for example six month.

This would introduce a cost – a “shaming cost” – for being biased. Obviously the individual FOMC member could still vote as they please and there wouldn’t necessarily have to be a consistency between their voting and their forecasts, but it is likely that too large inconsistencies between voting and forecasting would cause quite a bit of embarrassment for the most biased FOMC members. This I believe would do quite a bit to reduce cognitive dissonance among the FOMC members.

It should be noted that the FOMC actually has moved a bit in this direction over the last couple of years, but in my view the cost to the individual FOMC of being biased is still very small and cognitive dissonance therefore seems to dominate monetary policy making.

PS this post is actually a bit of an attempt to start dealing with my own problems with cognitive dissonance. I am not sure that I am succeeding, but I am at least trying to think of methods to get around cognitive dissonance problems.

UPDATE:  A couple of readers have suggested that I use the term “cognitive dissonance” in a wrong way. I surely acknowledge that I am a bit (maybe a lot) sloppy with the term here and it might have been more telling (or correct) to use the term “confirmation bias” instead or even Bryan Caplan’s term “rational irrationality”. This does, however, not change the conclusions.

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Bryan Caplan is right – free market economists should worry deeply about unemployment

Bryan Caplan has a very good blog post over at Econlog on “The Grave Evil of Unemployment” and on why free market economists should be deeply concerned about unemployment. I strongly agree with Bryan on this topic (and most other topics) – free market economists are often far too nonchalant about unemployment.

This is Bryan:

I know hundreds of free-market economists.  They’re friends of mine.  Indeed, I’m a free-market economist myself.  It saddens me to say, then, that our critics are often right.  While some free-market economists merely doubt the efficacy of policies intended to alleviate unemployment, the average free-market economist doesn’t take the unemployment problem seriously.

Why not?  At the level of high theory, free-market economists love market-clearing models.  If there’s surplus wheat, the price of wheat will fall to clear the market.  If there’s surplus labor, similarly, the wage will fall to eliminate unemployment.  What about nominal wage rigidity?  Most free-market economists concede that nominal wage rigidity exists to some degree, but think the problem is mild and short-lived: “It’s been three years.  The labor market must have fully adjusted by now.”

High theory aside, though, free-market economists have a toolbox of quips they use to belittle the problem of unemployment.

There’s the argument from the safety net: “Why would anyone want to go back to work when he can collect 99 weeks of unemployment insurance?”

There’s the argument from relocation: “There are plenty of jobs in North Dakota.  Anyone who refuses to move there is therefore voluntarily unemployed.”

There’s the argument from worker hubris: “If he’s an ‘unemployed carpenter,’ then I’m an ‘unemployed astronaut.'”

There’s the argument from Zero Marginal Product: “If the guy can’t find a job, his labor must be worthless.”

I am afraid Bryan is right – most free market economists tend to belittle the problem of unemployment. That is too bad as unemployment is a massive economic and social problem both in the US and particularly in Europe. In fact it is likely the most important economic problem of the day. No matter the causes unemployment is a grave evil and free market economists should be deeply concerned about the rise in unemployment over the past five years.

Among the reasons why many free market economists seem careless about unemployment is that many of them tend to think of unemployment as a necessary evil – this especially seem to be the case for some Austrian school economists. Hence, they tend to think that rising unemployment is a natural consequence of reallocation of economic resources after an unsustainable boom has come to an end. That might very well  sometimes be the case, but that does not make unemployment less of a problem.

I would further add that free market economists tend to think of unemployment as a result of “government failure” – too high taxation, overly generous welfare benefits, minimum wages, rigid firing and hiring rules etc. I agree that unemployment both in the US and Europe is higher because of such failed regulation. However, the present unemployment problem in both the US and Europe is not a supply side problem, but rather a demand side problem and it is clear that many free market economists have a hard time dealing with demand side problems as they tend to think that if we have a demand side problem then it is a justification of Keynesian demand management policies (fiscal policy).

Obviously Market Monetarists like myself would – in line with Keynesian economists – argue that the rise in unemployment over the past five years primarily is a result of a collapse in aggregate demand. This drop has, however, not been caused by an inherent instability of free markets, but is a result of “government failure” or more precisely is a result of monetary policy failure.

Market Monetarists argue that we can avoid monetary policy failure if central banks adopt an NGDP level target and that would also minimize involuntary (demand side) unemployment (that is an positive side-effect rather than the main purpose however).  There is nothing “Keynesian” about this, but it acknowledges the fact that failed monetary policy can lead to involuntary unemployment.

Bryan’s solution to the unemployment problem is the following:

“Instead of downplaying the grave evil of unemployment, we free-market economists should urge governments to redouble their efforts to fight it.  How can we do so and remain free-market economists?  First and foremost, by emphasizing the obvious: Every government imposes a vast array of employment-destroying regulations.  Minimum wages.  Licensing laws.  Pro-union laws.  Mandated benefits – especially mandated health insurance.  Anyone who appreciates the grave evil of unemployment should bitterly oppose these regulations – and vigorously reject the cavalier, callous view that a heavy-duty safety net is a good substitute for a job.  Government regulation is hardly the sole cause of nominal wage rigidity, but it definitely makes a bad situation worse.”

I wholeheartedly agree with Bryan on this. So while I believe that most of the rise in unemployment in particularly Europe has been caused by a collapse in aggregate demand I also think that countries like Spain have  massive structural problems that causes unemployment – particularly youth unemployment – to be much higher than it should be.

However, Bryan also acknowledges the demand side problem:

Isn’t monetary policy is a far more effective and sustainable way to boost Aggregate Demand?  Sure.  Given the existence of a central bank, though, it’s hard to see why free-market economists should run away from this conclusion.  How is Nominal GDP targeting any less free-market than constant growth in M2, or a frozen monetary base, or short-run interest-rate targeting?  I think this is the closest Bryan has ever come to endorse NGDP targeting and I like the way he do it: Given the existence of a central bank (Free Banking would be preferable) then NGDP targeting is no less of a free-market alternative than constant money supply growth or a frozen monetary base.

I certainly agreee or rather I think that NGDP targeting is the true free market alternative and is significantly more free market than other central bank based “solutions”. I have explained this position in a number of blog posts. See for example here and here.

Finally Bryan touches on what I would consider a very Friedmanite argument for NGDP targeting:

If, as seems highly likelyScott Sumner is right to blame the Great Recession on central banks’ tight monetary policies, free-market economists should not be afraid to honor him.  Imagine how much statist legislation could have been averted if the world’s central banks had kept NGDP on a steady course from 2008 to the present.

This I think is an extremely strong argument for NGDP targeting. As a consequence of overly tight monetary policies in Europe and the US unemployment has spiked and economic activity has slumped – and caused serious financial distress. These evils are now being blamed by policy makers across the world as being a result of the failure of free markets. Nothing could of course be further from truth, but that does not change the fact that interventionists policies are now been introduced in both the US and in Europe to curb the “excesses of free markets”. I doubt for example that US minimum wages would have been increased to the extent we have seen had we the rise in unemployment been curbed by an NGDP targeting policy and fiscal policy would certainly not have been eased to the extent we have seen. Not to talk about that draconian financial market regulation being passed these days.

NGDP targeting seriously reduces the problem of involuntary unemployment and as such a consequence undermines the case interventionist policy. Therefore, any free market economist who are concerned about the economic and social implications of high and rising unemployment should of course endorse NGDP level targeting. I think Bryan just did even though he is reluctant to admit it.

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Cato-Unbound.org. Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

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