Friday, May 29, 2009

Deal or No Deal Part 2

I received a curious comment to the last post Revenue Write-Down: Deal or No Deal:
Rudd's budget strategy exhibits extreme political risk aversion. It would be a mistake to view it in economic terms.
This is in line with what many commentators have said was the way the budget addressed the economic recession in the near-term while avoiding the hard choice of dealing with the long-term structural imbalances identified by the Federal Treasury in its budget papers.

In part 1 of this entry, I had contended that Prospect Theory explained the way the Labor government was behaving in assessing the risks associated with the budget allocation decisions on spending and taxation. The theory predicts (accurately in my view) that faced with losses, the government would increasingly become risk-seeking as shown by its having thrown caution to the wind and engaging in deficit spending.

I failed to mention another aspect to this risky decision. This has to do with what US Defense Secretary Donald Rumsfeld made famous: the “known unknowns” or the things that we know we don’t know. In a word it’s called ambiguity.

As it turns out, the human brain has a bias against it, an aversion. When faced with a decision involving risk where the probabilities attached to events are unknown, humans prefer not to decide or to postpone a decision until the known unknowns turn into known knowns even when the risky decision involves a higher expected value. Ambiguity aversion has been shown to exist when the decisionmaker is experiencing the fear of negative evaluation (FNE) from others.

Here is a neat video explaning the theory of ambiguity aversion in relation to the Ellsberg paradox posted by another blogger.

Getting back to the comment, perhaps it was not a case of political risk aversion, but a form of ambiguity aversion. The government has in effect postponed the decision to rein in tax cuts, given the FNE associated with reliving the Keating Labor government’s experience in the last recession. And given that one single event assumed in the budget would resolve the issue for them (this is the GDP growth projection of 4.5% over six years) the probability of which was (and will remain for some time) unknown, it probably felt justified in delaying this hard choice.

As neuroeconomics shows, this is a powerful, evolutionary response that fits in perfectly with the human condition. Until ample evidence arises to clear the ambiguity or reduce the FNE associated with the structural adjustment task, we cannot reasonably expect the government’s response to be otherwise.

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