Daniel Kahneman at Princeton University in 2002 (AP Photo/Brian Branch-Price).
Daniel Kahneman at Princeton University in 2002 (AP Photo/Brian Branch-Price).

A consequence of the financial crisis is the rising prominence of the field of behavioral economics. One of the most distinguished proponents of the view that the rational agent so commonplace in economic models does not exist is Daniel Kahneman, 2002 Nobel Laureate in economics. In the remarkable book Thinking, Fast and Slow Kahneman argues that while some decisions rely on intuition, others are deliberate and require reasoning and deduction. I was reminded of Kahneman’s wonderful work in thinking about the seemingly endless bad news, occasionally interrupted by the occasional hopeful news, from Europe.

I see financial market participants as belonging to the thinking fast group. One day the Dutch government falls and stock markets around the world experience triple digit losses, the next day the bond auction for Dutch government debt surprises in a positive way and stock markets begin a rebound, though this was undercut a day later by continuing bad news from Spain. In the meantime some policy makers, usually German officials, continue to insist that deficit targets need to be met at all costs while reasoned officials and observers insist that without a Eurobond, a growth compact, fiscal union, or all of the above, the euro is doomed to failure.

In many respects, both the fast and slow thinkers are correct. The fast thinkers discount the future to such an extent that every bit of ‘new’ information produces renewed convulsions in equity and foreign exchange markets. The fast thinkers are also convinced that their intuition about the desirability of maintaining austerity programs under recessionary conditions is the right medicine. As Kahneman (op. cit., p. 217) tellingly remarks: “We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers.” In spite of the fact that some have made the obvious point, namely that austerity without the prospect of adequate economic growth, is a recipe for failure, the fast thinkers see the world “...as more tidy, simple, predictable, and coherent than it really is. The illusion that one has understood the past feeds the further illusion that one can predict and control the future.” (Kahneman, op.cit., p. 204-5) As a result, the fast thinkers roil markets, create added volatility is asset prices, and generally help retard the return to normality and a more optimistic future.

In contrast, the slow thinkers ask what kinds of reforms can prevent the euro area from shrinking, if not collapsing altogether. The problem for the slow thinkers is that they recognize that existing institutions such as the European Central Bank (ECB) may need reforming while entirely new institutions, or significant reforms to existing institutions, such as the European Commission, will require new Treaties or agreements dealing with complex issues among a large number of diverse members. All of these steps take time, and involve a considerable amount of political wrangling and compromise.

The slow thinkers hope to save the euro area by taking small steps in the knowledge that bigger steps are essential to repair a monetary system that has deep flaws. The question is whether the slow thinkers have time on their side. Black swans lurk in the background and, while it is hoped that the slow thinkers will eventually prevail, it is far from certain that this will happen. Politicians may be correct that they, and the public, are attached to the euro and the ideals of European integration. Will the fast thinkers spoil it for everyone?

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