George A. Akerlof – Phishing for Phools

Warwick Economics Summit is one of the largest student-run academic conferences of its kind in Europe, and it was an honour to welcome Nobel Laureate Professor George Akerlof to this year’s event at the University of Warwick. Prof Akerlof co-won the Nobel Prize in Economic Sciences in 2001 with Joseph Stiglitz and Michael Spence for their pioneering work on asymmetric information. In his upcoming book, Phishing for Phools, Prof Akerlof aims to “challenge the view that whatever markets do is right”. He claims “we all know about Phishing for Phools, but it cannot be published in journal form because we all know it!”

Prof Akerlof is best known for his paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism”. This utilised the used car market to demonstrate the pitfalls of information asymmetry resulting in the sellers of good quality used cars not being able to sell them. The reason for this, says Akerlof, is that buyers have no way of knowing which cars are of good quality in the market, and are not willing to pay more than the value that they place on an average quality car, which is in turn less than what the seller is willing to sell their car for.

“Only a slight change of assumptions yields quite different results,” says Prof Akerlof. If buyers do not have rational expectations, they “don’t know what they don’t know”, and ignore the possibility of adverse selection. In this instance, used cars are sold, but some buyers gain by getting a better than expected car while others lose out by getting a worse than expected car. So, although trade can now occur, some buyers lose out. Prof Akerlof says this shows “markets serve a positive purpose of letting people trade but if people are naïve, markets will take advantage of them”. This is the basic theory behind Phishing for Phools. “From nuclear generators to chainsaws, our most powerful tools are the most dangerous” says Prof Akerlof. The most powerful social and economic tool is the free global market. “But they also allow a great deal of harm,” says Prof Akerlof. “Free markets”, he argues, “seek out emotional and cognitive weaknesses which take advantage of failures to understand that we don’t know what we don’t know”.

What is a Phool? Prof Akerlof defines a Phool as someone who makes a perfectly intelligent decision, which happens to be a mistake. Free markets ‘phish’ for phools by making us do things which are good for others, but not necessarily good for ourselves. But what happens if we ignore the phish? In the United States, one third of the population is obese. Does the free market help society combat obesity? On the one hand, there are tools like weight-watchers, Diet Coke and even vegetables which could decrease instances of obesity. But if you go to any shopping mall, Prof Akerlof explains, Cinnabon sellers “aren’t shy about letting the smell of the Cinnabons waft out” encouraging obese people to consume even more calories. This is a classic example of a phish for phools. This is a metaphor for the temptations that the market is putting in our path to do something which isn’t necessarily in our best interests. Continual temptation is an inevitable by-product of capitalism. From shop windows to supermarket aisles we are continually tempted to part with our money and do things which may not necessarily be in our best interests.

Prof Akerlof says “Phishing for phools gives an extremely succinct explanation for the Great Recession”. Reputations of ratings agencies such as Moody’s and Standard and Poors have been built up by over a century. Their job was to rate the probability of default of bonds. But in the late 1990s and early 2000s the ratings agencies took on the task of rating more complex derivative securities. These securities were nearly impossible to rate accurately since the underlying mortgages were so inaccessible. “The public would believe whatever ratings were given to them by the agencies,” says Prof Akerlof. By analogy “Rotten avocadoes were rated perfect”.

The value of these securities reflected their ratings, allowing commercial banks, investment banks and hedge funds to borrow huge amounts of money short term, invest in the over-rated securities and pocket profits from the interest spread on every dollar of investment. The rotten securities were used as collateral and when financial institutions realised the securities were rotten, many institutions owed much more than they owned. This raises four questions, says Prof Akerlof:

•  How were the reputations of the ratings agencies originally established?

•  What made it profitable then to mine these reputations?

•  Why were the buyers of the rotten securities so naïve?

•  Why was the financial system so vulnerable to the discovery of rotten securities?

“It’s so easy economics,” says Prof Akerlof “that nobody really bothered to think about it and answer it because everybody would have been presumed to have known all of this.” He concludes with the remark that “Markets may be good, but every knife is a two-edged sword”.

This article was written by Winston Yap for the Warwick Knowledge Centre.  You can read the original article and watch a video of Prof Akerlof here.