Sunday, October 16, 2011

We are APES

In an article in the October issue of Quadrant, Paul Monk labels homo sapiens as Apprehensive Pattern-seeking Emotional Story-tellers or APES. As nice a summary of our cognitive nature as I have come across.

Paul Monk writes:
As neuroscientist William Calvin puts it, our brains are susceptible to colourful rhetoric, to being swept along by group dynamics that overwhelm our emotional autonomy and critical faculties, to finding hidden patterns where none exist. They are highly susceptible for these reasons to myths, stories, superstitions and mass emotions. Our memories are selective and unreliable, our decision-making easily swayed by the last thing to make a vivid impression on us; our intuitions about logic, probability and causation are powerful but flawed in a number of ways and these flaws are actually magnified rather than diminished by our creation of complex, increasingly data-dependent social orders.
Given Paul Monk is a principal of Austhink, cognitive biases are his meal ticket.

A fine, if somewhat poetic, description of our Apprehensiveness is provided in John Carroll's flawed-but-engaging (and interestingly flawed) book Jerusalem, Jerusalem: Wow the Ancient City Ignited the Modern World:
Fear is the dread of the known threat. Angst is the dread of the forever unknown, what is essential to becoming. The future does not hold danger, the future is danger. ...
Animals live in the eternal present. Humans live in the eternal coming-into-being. Angst, not fear. ... the inevitable incompleteness of experience, a being that is always becoming. What we call intellect is compelled to record that incompleteness in two dimensions, time and space.Time is measured against the past and the future -- memory and anticipation (Pp28-9).
While he somewhat exaggerates the gap between us and animals (such as higher primates), what Carroll is alluding to here is a distinction in our expectations about the future. Economist Frank Knight famously distinguished between risk and uncertainty:
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. ... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
To put it more simply, uncertainty is risk that is immeasurable, not possible to calculate. But both are about anticipation, apprehensiveness, expectations: about looking forward.

As anyone in business knows, risk is heterogeneous. For example, small business copes with the unknown variances in hiring new people by using any risk-minimising techniques that are available (notably, use of networks that provide implicit “guarantees”: as in “I don’t know X but they were recommended to me by Y, who I do know and I do not believe Y wants to damage their connection to me by recommending a dud”). Large businesses, more able to cover risk and less able to directly connect effort to output, compensate by paying a “corporate premium” that acts as a “hostage” for productive behaviour by the employee. (I see no particular reason why training profiles—which are often used to explain the wage premium in large corporations—should be greatly different between large and small businesses: difficulties of supervision strike me as far more differentiating.)

Interest rates, asset prices and assessments of risks are intimately connected. As David Glasner notes:
... interest rates emerge out of the process of evaluating all durable assets, which are nothing but claims to either fixed or variable future cash flows of various durations and risk characteristics. ... One of the good things about Milton Friedman’s 1956 restatement of the quantity theory of money was his explicit recognition that interest rates are determined not in a narrow subset of markets for fixed income financial assets, but in the complete spectrum of interrelated markets for long-lived physical and financial assets.
(There are some complications in this, which need not detain us for the moment.) What makes an asset an asset is its potential for future use.

In aggregate terms, it is generally reasonable to assume that risk in an economy “bell curves”—that failed judgements of risk and successful judgements of risk cancel out around a positive mean. [If that mean is positive, risk assessments on average are too high and will tend to fall: if the mean is negative, risk assessments on average are too low and will tend to rise.] But suppose some economic shock leads to a sudden downward shift in the general ability to meet established obligations: the [previous experience] assumption of successful overall coverage of risks may [will] no longer apply. There will [likely] be an increase in people’s preference for holding money (to reduce their exposure). Ironically, the overall risk profile of the economy [will then tend to] may improve, since bankruptcy and closure will disproportionately hit those on the tail end of the risk bell curve. The effect will [then] be to put downward pressure on interest rates, reflecting shifting assessments of risk.

In this situation, there may well be an increase in (negative) uncertainty: but this will not be directly reflected in interest rates because these cover only risks-as-calculated. Prices cannot directly incorporate what cannot be calculated but can and will reflect the consequences of uncertainty’s effect on behaviour.

I say negative uncertainty because, as George Ip notes:
… it is not “uncertainty” per se that bothers business. Whether uncertainty is unwelcome depends entirely on what’s at stake. What would you prefer: 100% probability of dying next year, or 50%? Most of us would choose the latter. Similarly, business would prefer zero probability of a burdensome new rule, but if that’s not possible, would certainly take 50% probability over 100%. The administration’s decision to delay implementation of a new ozone standard perpetuates uncertainty. Business welcomed it nonetheless because now they do not have to spend money to meet it for at least two years, and perhaps forever if in the interim a new president chooses never to implement it. Does the Federal Reserve create some uncertainty when it undertakes quantitative easing? Probably, but in the process it makes the stability of inflation around 2% much more certain, and that, most businesses would say, is a reasonable trade-off.
In the absence of any ability to calculate, the framing through which one views the incalculable determines responses. A classic instance of uncertainty shifting from positive to negative is that, when the stock market was booming during the late 1920s, lack of information over the weekend would be interpreted positively. As and after it crashed, lack of information was interpreted negatively.

Economic “confidence”—including business confidence—is, to a large degree, how what cannot be calculated is being framed in a given time period: whether it is being framed positively or negatively and how much so. This is likely to be based on various indicators but, by its non-calculable nature, cannot be definitively so. The wider the range of uncertainty, the more unstable confidence is likely to be, because the greater the possibility of new information changing how the uncertainty is being framed.

Just because something cannot be calculated does not mean we will not frame expectations to cover that uncertainty: it just means that such expectations cover more than is directly inferable from such information as we have. We will apprehensively tell stories based on (at least partly created) patterns that fit with our preferences, because we are APES. But, of course, without preference and expectations we would have no basis to act (other than randomly). Being APES may go with the territory of having a certain level of cognitive complexity.

[Cross-posted at Critical Thinking Applied]

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