Markets and memory

Kahneman and Tversky, two founders of the behavioral economics school of thought, conducted a simple experiment to indicate what they called the “anchoring bias.” People were asked, “How many African nations belong to the UN?” Before they answered, the experimenters spun a “wheel of fortune” with numbers on it. Those who saw a high number on the wheel tended to guess high on the number of nations, those who saw a low number, guessed low. The wheel had nothing to do with African nations and the UN, hence their term “an anchoring bias.” The wheel had established an irrelevant but compelling anchor.

This bias is among the many “cognitive biases” researchers have used to critique the conception of economic man as rational. But I think the term “bias” is itself biased. It suggests something that is misdirected and off-center. Anchoring is in fact one example of a much larger phenomenon; human beings have memories, these memories are linked to a sense of identity, and identities are never readily relinquished.

There is an even older saw in economics; “disregard sunk costs,” which means begin everyday as if you were born anew and optimize your allocation of capital accordingly. In other words, “what’s bygone is bygone.” Were this rule followed, all markets would clear immediately, housing would drop to its market clearing price however low, banks would write down debt to sell it on a secondary market at a few cents on the dollar. Kodak, a company that has struggled for over a decade to find its way into the digital age, and is about to run out of cash, would shut down tomorrow and simply auction off its over 1000 valuable patents, returning the money to shareholders.

But markets don’t clear like this. People have memories and desires. The ultimate anchor is, “who I was, and whom do I hope to continue to be,” e.g., a Kodak scientist, a responsible leader in Rochester, New York, where Kodak is headquartered, a home-owner in my community. Perhaps the only market that may not have a memory is the stock market itself, which according to many analysts moves randomly from day to day. But if the market for capital assets clears, while other markets, such as the labor market and the housing market, don’t, we are set up for gridlock.  If Kodak’s share price continues to fall, some other company may acquire it to get its patents, thereby avoiding an auction, and promptly lay-off most everyone, many of whom will not be able to sell their houses or be willing to accept minimum wage jobs. 

Karl Marx once famously characterized capitalism as a system in which “all that is solid melts into air.” But this is correctly understood as a fantasy about a society whose members have neither memories nor desires.