The Biases That Limit Our Thinking about the Economic Outlook and Policy

Article excerpt

To make effective private-sector decisions and government policy, it is important for those who make decisions and those who are impacted by them to know whether these decisions might be influenced by underlying biases. This paper enumerates and discusses potential biases, their sources, and how they might influence selected policies and decisions.

Business Economics (2012) 47, 297-301.

Keywords: bias, economic outlook, economic policy, markets, regulation

Effective economic policy--and important private economic decisions--begins with a thoughtful review of five facets of the economy--growth, inflation, interest rates, the dollar, and corporate profits. The purpose of this essay is to identify the biases that limit our perceived available choices and then relate these biases to the choices and to other aspects of economic policy making and private-sector decisions.'

1. The Sunk Cost Bias: Recessions Come, but Also Go

In the current recovery, the pace of growth is subpar compared with prior economic recoveries. This brings us to our first policy problem and the first bias that limits our perceived available choices. In his book, Into Thin Air, Jon Krakauer [1997] offers us an example of mountain climbers who seek to reach the top of Mount Everest. After a considerable expense of training, equipment, and time, the climbers reached the last camp before the approach to the summit. However, the approach to the summit was more difficult than anticipated, and a number of climbers who started the final ascent after the recommended last departure time subsequently died.

This real-world example brings up the problem of the sunk cost bias--the tendency to escalate commitment to a course of action while ignoring the mounting costs of the action relative to the anticipated benefit. In military terms, this is the story of many of the battles of the Somme, Ypres, and Verdun in World War I.

In economic policy today, the challenge is for us to judge whether another fiscal stimulus program, another quantitative easing, another housing program, or another financial regulation would be just enough to reach the top of the mountain, for example full employment, reestablish the strength of housing a la 2005-07 or greater financial stability than what we have achieved so far. Or could further policy moves be too much? Would we be violating some sort of economic rules or balancing act in the economy where the continued pursuit of these policies be counterproductive, such as bringing on too much federal debt that could not be repaid over time--a mini Greece perhaps? The basic question is whether the marginal cost of expanded policy actions would outweigh the marginal benefits of such actions--not how much has been done already. Of course, for the private sector, this is drummed into economists in their first encounter with the theory of the firm.

2. The Overconfidence Bias

Within the economic growth debate, we also face a second bias in our decision-making on policy choices. In the economic recovery of the 1960s, the belief was that the economic problems of the business cycle were solved and that adjustments in fiscal policy could be made to correct any economic deviation from the desired trend. In 1967, with rising inflation and rapid economic growth and the costs of the Vietnam War escalating, Congress voted in 1968 to pursue a temporary tax surcharge to fine-tune the pace of economic growth and reduce inflation. It failed on both counts and illustrates a second bias in our decision-making: the overconfidence bias, or the belief that our approach to any issue will succeed even though we may not have tested this approach before or applied it in a particular way. Think here, in military terms, of the invasions of Russia by Napoleon and Hitler.

In economic policy, this is the story behind many temporary fiscal stimulus programs and rebates, the cash-for-clunkers program, and the first-time homebuyer credit. …