Germany, a towering beneficiary of the euro, keeps sabotaging efforts to save the single currency. To understand why, pick up Daniel Kahneman’s imposing new book, “Thinking, Fast and Slow.”
Kahneman, an influential Princeton psychologist who won a Nobel Prize in economics, doesn’t discuss the euro debacle in this masterwork on intuition and decision making. He does describe a human trait that has helped drive the sovereign-debt crisis from Athens to Rome and on to Berlin: loss aversion.
The phrase is shorthand for an ingrained psychological quirk that surfaces in experiment after experiment. Simply put, people dislike losses more than they like gains. That instinct warps any negotiation, be it bargaining over labor contracts or deciding the fate of the European Union. Germans, seen in this light, are primed by history and psychology to believe they have more to lose than to gain from euro bailouts.
“Loss aversion creates an asymmetry that makes agreements difficult to reach,” Kahneman writes. “The concessions you make to me are my gains, but they are your losses; they cause you much more pain than they give me pleasure.”
This is only one slice of a highly readable and richly empirical study of our “mental machinery,” as Kahneman and his late collaborator Amos Tversky called it. The book, a sweeping synthesis of Kahneman’s research and thinking, offers plenty of other intellectual meat to be savored -- observations on hapless stock pickers and overrated chief executives, and an algorithm that predicts the future value of Bordeaux wines.
Systems 1 and 2
Yet I kept coming back to loss aversion, which is tripping up European ministers and keeping the bond vigilantes on their backs. If German Chancellor Angela Merkel wants to save the euro, she would do well to heed what Kahneman and other pioneers of behavioral economics have learned.
Our cognitive equipment is composed, in Kahneman’s extended metaphor, of two systems that determine how we think and make choices. System 1 is fast, but runs on intuition and emotion. (Do we trust that Neanderthal with the baseball bat in the dark alley?) System 2 is slower, more critical and more logical. (What’s the product of 17 x 24?) No points for guessing which system has the upper hand in loss aversion.
Throughout our lives, we face choices that combine the risk of loss with the opportunity of gain. Should you take that job in Dubai? Would you buy shares of Facebook Inc. in a private sale before the company goes public? In each case, you must decide whether to accept a gamble or reject it, Kahneman writes.
He likens such choices to a coin toss. Tails, you lose $100; heads, you win $150. Though the expected value of the gamble is positive, most people dislike it, he says. Their fear of losing $100 overpowers their hope of gaining $150. Many demand a potential gain of at least $200 to balance the possibility of losing $100.
Our loss aversion is rooted in evolution, Kahneman says: “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce,” he writes.
Which helps explain why Germany bridles at suggestions that it should make a bigger contribution to save the single currency, support the introduction of joint euro bonds, or allow the European Central Bank to become a lender of last resort.
Germany should be praising the euro, not burying it. The ECB, after all, kept interest rates at levels more appropriate to Germany than to Ireland or Spain in the euro’s first decade. That helped pull Germany out of a balance-sheet recession and aided its exports. Think of Greeks buying Porsche Cayennes as the good times rolled.
When the bubble burst, the Germans benefitted from the currency union yet again, as Sebastian Mallaby, author of hedge-fund history “More Money Than God,” has noted. Imagine what would have happened to Germany’s resurging exports in 2009 and 2010 if the country had, like Switzerland, been outside the euro and seen its currency surge on an influx of hot money.
Instead, capital flowed into German government bonds from the periphery, driving down the country’s borrowing costs. Heads, Germany wins; tails, its euro partners lose. Until, of course, investors got so nervous about the euro that Germany itself struggled to sell 10-year bonds at an auction last week.
Reading Kahneman’s book has deepened my appreciation of Germany’s reservations. Germans are right to be vigilant about the moral hazard engendered by transfer unions. Nor should we brush off their historical fears of hyperinflation, the subject of a timely reissue of Adam Fergusson’s classic history, “When Money Dies.”
Yet Germans would be wise to stifle their System 1 long enough to allow their System 2 to calculate the real value of saving or losing the euro. Is this a risky gamble? Yes. But Germans have far more to gain than to lose.
“Thinking, Fast and Slow” is from Farrar, Straus and Giroux in the U.S. and from Allen Lane in the U.K. (499 pages, $30, 25 pounds). To buy this book in North America, click here.
(James Pressley writes for Muse, the arts and leisure section of Bloomberg News. The opinions expressed are his own.)