Book Review: Phishing for Phools
Phishing for Phools: the economics of manipulation and deception. 2015. George A. Akerlof and Robert J. Shiller.
“This crisis has reminded us that without a watchful eye, the market can get out of hand. – President Barack Obama, 2009 inaugural address
In real life, people differ from the rational agents described in economics textbooks. We can consume oversized carbonated drinks that make us fat. We can increase our risk of an early, costly and horrific death by smoking cigarettes. In the grip of overconfidence, we can buy lottery tickets and invest in hedge funds. In the face of abundant and explicit information on how we deviate from rationality, ranging from scholarly works like the “Theory of Perspective” by Daniel Kahneman and Amos Tversky to treatises as popular as Kahneman’s Think, fast and slow and that of Jonathan Haidt The right mindWe humans persist in making choices that are not aligned with our best interests.
In Phishing for seals, a collection of stories about profit from deception, Nobel laureates George Akerlof and Robert Shiller discuss the effects of so-called irrational human behavior on financial markets. They explain that in the absence of regulation, someone will always be ready to exploit our irrational tendencies, leading to a “phishing balance” in which individuals are harmed. Akerlof and Shiller argue that we can do better.
According to Wikipedia, phishing is an attempt to acquire sensitive information by a malicious online entity masquerading as a friend, and the term dates back at least to a 1987 presentation to INTEREX, the International Association of Computer Users. Hewlett-Packard. Early phishing expeditions included an attempt in 1995 to acquire passwords and credit card information from AOL users with a program called “AOHell”. In the book, the term “phishing” is taken from its standard usage for “contemporary fraud”.
Akerlof and Shiller tell how Goldman Sachs has undermined its reputation as a “trusted friend” to sell high-rated but worthless securities to clients as the financial crisis approaches. They describe the deceptive accounting that led to the savings and loan crisis in the United States in the late 1980s and early 1990s. They also recount how pharmaceutical giant Merck fell out of favor by ignoring a internal memorandum showing that his “wonder drug” Vioxx caused heart attacks.
The authors argue that sound government regulation has protected us from fraud in the past, but a currently popular “new story” in which government regulation is bad overlooks this part of the story. This idea is supported by the book by Jane Mayer Black silver, which documents how right-wing and libertarian organizations backed by business and billionaires actively promoted this “new story.”
In the “old story” that emerged after the Great Depression and World War II, Akerlof and Shiller note that “the government could be a useful counterweight to the excesses of free markets”. They refer to Social Security, enacted by President Franklin D. Roosevelt in 1935. Using the rhetoric of the “new history” of the free market, the George W. Bush administration attempted to introduce self-administered individual accounts in social security in the mid-2000s. Would such a system have favored our best interests? Based on historical simulations detailed in Shiller’s 2005 article “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” the authors conclude that increasing the freedom of investors to manage their social security benefits would likely have been disastrous.
Phishing for seals contains useful information for all types of financial market participants. For an individual investor, the message is Warning. Investment professionals might consider the importance of alerting clients to market pitfalls. Financial specialists may find motivation to develop behavioral models as influential as rational models. In the best case, Phishing for seals could help revive the “old story” in which government regulation can elevate the common good.
Despite the book’s strengths, the authors sometimes show poor judgment about what to say and what not to say. Many stories are hard to follow, and at least one is in bad taste. To illustrate how news anchors and advertisers come to our attention, Akerlof and Shiller describe the mysterious 2013 disappearance of Malaysian Airlines Flight 370 as “inconsequential in the grand scheme of things.” I wish this book had been edited more thoroughly.
According to the free market economy, individuals promote the common good by pursuing their selfish interests. In this framework, the individuals concerned are rational agents, and the promotion of the common good is the work of the “invisible hand” of Adam Smith:
“He is only aiming for his own gain, and he is in this case, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. . . . By pursuing his own interest, he often promotes that of society more effectively than when he actually intends to promote it.
The first fundamental theorem of welfare economics formalizes the concept of the invisible hand. He says that free markets lead to an optimal Pareto equilibrium, in which no individual can be improved without another being degraded. This balance is at the heart of the argument for deregulation.
How do we create effective and sustainable regulation that protects us from fraud without limiting our freedom? Answering this question is difficult because human behavior is disorderly and Phishing for seals does not provide an answer. Instead, the authors suggest that we need behavior analogous to the concise and powerful quantitative models that underpin rational economics. With behavioral equilibrium at the heart of a “fundamental theorem of the economics of human welfare,” we may finally be able to adopt regulations that keep financial markets from spiraling out of control.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.