Greece crisis: Remember - when people's backs are against the wall they will take big risks

If Greece embraces default and exits the single currency it would cause immediate and severe economic pain

(Reuters)

What does the Greek Prime Minister have in common with the men who ran big banks on the eve of the global financial crisis?

It’s not obvious. Alexis Tsipras is a former Communist activist who named his son after Che Guevara, while the bosses of giant financial institutions like Dick Fuld at Lehman Brothers and Fred Goodwin at the Royal Bank of Scotland were self-styled heroes of unfettered global capitalism. Yet in both cases their behaviour reflects a common psychological trait: a risk-seeking preference in the face of a guaranteed loss.

Amos Tversky and Daniel Kahneman nailed down this tendency in a paper in the journal Econometrica in 1979, using their own research. When they offered a sample of people a choice between receiving $3,000 for sure and an 80 per cent chance of getting $4,000, the vast majority said they would take the $3,000. But when they offered the same group a choice between a guaranteed loss of $3,000 and an 80 per cent chance of losing $4,000, things were reversed. The majority opted to take the gamble.

The standard theory of economic decision-making at that time suggested that people made “rational” choices based on the mathematical “expected value” of gambles and on an objective appraisal of how the outcome of the gamble would change the state of their existing personal wealth. If this was true, people would not have behaved as the psychologists found in their tests.

This is somewhat simplified, but Tversky and Kahneman’s essential breakthrough was to show that we are subject to powerful and emotion-driven mental biases when we make decisions involving risks, which can make our behaviour look inconsistent. In decisions involving guaranteed gains we put a large premium on certainty. And in the realm of guaranteed losses we are often willing to take what can seem to outsiders as reckless gambles.

Which brings us to Greece. Its economy has been ravaged over the past five years due, in no small part, to the colossal dose of austerity imposed by the country’s creditors in the International Monetary Fund and the European Union in exchange for bailout cash. And now the creditor powers are insisting on still more austerity as the price of releasing more money that Greece needs to avoid a default. The alternative for Greece is to embrace default and exit the single currency. But this would cause immediate and severe economic pain – even more pain than the extra austerity demanded by creditors. Yet there is also a chance that if Greece refuses, the creditors, who don’t really want the country to leave, will relent and ease their demands, meaning that Greece can remain in the single currency without more austerity.

Both options look pretty bad. And it’s a guaranteed loss (accepting more austerity) versus a bigger probable loss (marching towards default). So, as students of Kahneman and Tversky might have predicted, Tsipras and his party seem minded to take the gamble with a small chance of a good outcome.

Now consider the bankers in the financial crisis. By 2007 the sector was in crisis. The lending markets were freezing up, indicating that the financial system was riddled with bad debts. Two options were available to banking titans. First, they could write down the value of the dodgy assets on their balance sheets. That would have meant reporting big losses and the executives losing their jobs and reputations. Second, they could plough on, rolling over bad loans, watching global economic conditions deteriorate still further and, probably, ending in an even bigger financial disaster for them personally (these banks’ bosses usually had a large portion of their own wealth tied up in the shares of their banks). But under the second scenario there was also a slim chance that something would turn up which would save them, such as a government bailout. So two unattractive options: a guaranteed loss versus a probable bigger loss. Again, as Kahneman/Tversky followers would have predicted, the bankers chose to gamble on the small chance of an external rescue.

This kind of risk-seeking behaviour can be seen in many areas of life. Patients with life-threatening conditions are often more willing to choose risky treatments as their condition deteriorates. Farmers who face losing an entire crop due to drought splash money on unproven techniques like cloud-seeding. Political leaders in a domestic fix even gamble by starting foreign wars. It’s the same instinct that prompts gamblers, at the end of a long night of losses at the casino, to put all their remaining money on the final spin of a roulette wheel.

For others to break this risk-seeking dynamic there would seem to be two avenues. Either change the framing of the choice faced by the subject – to shift them mentally from the mental domain of losses to the domain of gains – or change the perceived incentives. Eurozone politicians appear baffled that Greece would risk economic catastrophe by flirting with default. But they should have considered how things look from Athens after five years of economic agony and, perhaps, offered more eye-catching incentives to do a deal.

Some, notably the former Federal Reserve chairman Alan Greenspan, were similarly baffled when bank chief executives drove their institutions over a cliff in 2008. This failed to recognise how things looked from the banks’ boardrooms, where the urge to gamble for resurrection was overpowering. The solution here was to make it clear to the bank chiefs that any state bailout would still have meant them losing their jobs, wiping out the slim chance of a good outcome and changing their mental calculations.

Despite the Kahneman/Tversky breakthrough we often forget that people are subject to biases such as risk-seeking behaviour and assume that people calculate costs and benefits accurately and consider them dispassionately.

In such a world Greece’s leaders might have long ago accepted creditor’s demands. And bust bankers would face up to losses early on. But observing how people actually behave when their backs are against the wall teaches us that this is not the world we live in.

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