Through a glass darkly: the economy and confirmation bias in the econoblogosphere

For most of the last few years, I have been labeled a perma-bear, that is someone who looks at the situation from a reflexively skeptical glass half-empty bias. One only need peruse our archives to get that impression. In fact, that is hardly the case. Over the past few months, as the evidence of a potential bottoming has grown stronger, I have moved away from the bearish view toward a more bullish stance.  Yet, I do get the distinct impression that many commentators in the blogosphere do not share my renewed optimism. Their view is rather dark. Mind you, I am no out-and-out wild eyed bull.  Nevertheless, I do think my increasingly upbeat views stand in contrast to most of what you read in the blogosphere about the economy, the market and the banking industry.

Why is that?

Here’s my take.  Humans are naturally pre-conditioned to seek confirmatory evidence once they have made a conclusion.  We spend a lot sorting out new information into a world view and we become attached to this view emotionally, so much so that contradictory evidence is viewed as a threat not only to our views, but an imminent threat to our person.

Drew Westen, a Professor of Psychology at Emory University did a fascinating study about this theme in 2006 regarding politics. Wikipedia sums up the study and conclusions as follows:

In January 2006 a group of scientists led by Westen announced at the annual Society for Personality and Social Psychology conference in Palm Springs, California the results of a study in which functional magnetic resonance imaging (fMRI) showed that self-described Democrats and Republicans responded to negative remarks about their political candidate of choice in systematically biased ways.

Specifically, when Republican test subjects were shown self-contradictory quotes by George W. Bush and when Democratic test subjects were shown self-contradictory quotes by John Kerry, both groups tended to explain away the apparent contradictions in a manner biased to favor their candidate of choice. Similarly, areas of the brain responsible for reasoning (presumably the prefrontal cortex) did not respond during these conclusions while areas of the brain controlling emotions (presumably the amygdala and/or cingulate gyrus) showed increased activity as compared to the subject’s responses to politically neutral statements associated with politically neutral people (such as Tom Hanks).

Subjects were then presented with information that exonerated their candidate of choice. When this occurred, areas of the brain involved in reward processing (presumably the orbitofrontal cortex and/orstriatum / nucleus accumbens) showed increased activity.

Dr. Westen said,

None of the circuits involved in conscious reasoning were particularly engaged… Essentially, it appears as if partisans twirl the cognitive kaleidoscope until they get the conclusions they want… Everyone… may reason to emotionally biased judgments when they have a vested interest in how to interpret ‘the facts.’

In essence, political partisans with a well-developed political world view were confronted with data that did not fit their particular view.  This created cognitive dissonance and mental stress (remember, the brain areas for reason were not activated here, emotions were at play).  Their brains, rather than trying to resolve the conflict objectively, looked for ways to incorporate the new information into the previous pre-conceived view. When the subjects successfully accomplished this back flip, they were massively rewarded by the areas of the brain for pleasure.

In sum, our brains are NOT hard-wired for non-confirmatory evidence. We are not rewarded for seeking non-confirming data. Therefore, we generally seek confirmatory evidence after we have made any decision.

Think about this for a second.  When you have bought a car, a house, quit a job, gotten a divorce, taken on a new job, what have you – did you sit around looking for ways to figure out why those decisions were wrong? Unless, you are a masochist or in need of some serious therapy, the answer is no.  My reasoning is that there is no evolutionary benefit in one questioning decisions that have already been made.  The problem, of course, is that this search for confirmatory evidence extends beyond decision-making to how we view the world and how we interpret data and I believe it makes for errors in investment decisions and forecasting.  This problem is called the confirmation bias.

Wikipedia defines confirmation bias as follows:

In psychology and cognitive science, confirmation bias is a tendency to search for or interpret new information in a way that confirms one’s preconceptions and to avoid information and interpretations which contradict prior beliefs. It is a type of cognitive bias and represents an error of inductive inference, or as a form of selection bias toward confirmation of the hypothesis under study or disconfirmation of an alternative hypothesis.

Confirmation bias is of interest in the teaching of critical thinking, as the skill is misused if rigorous critical scrutiny is applied only to evidence challenging a preconceived idea but not to evidence supporting it.

So, to be clear, I am saying that we all are biased toward the pursuit of evidence that confirms what we already tend to believe.  If that view is false, we are merely entrenching ourselves more in a false belief.

John Maynard Keynes once famously quipped, “When the facts change, I change my mind. What do you do, sir?.” I applaud him for the sentiment.  But, the fact is, it is easier said than done. As a result, every step along the way, I force myself to revisit my conclusions over and over again, specifically looking for non-confirming evidence.  My post “Channeling my inner Larry Summers” was an example of that.  But, quite frankly, I find the exercise very taxing mentally – emotionally draining, if you will.  So I am sure that I am not always successful.

Well, the facts have changed.  The U.S. economy, which I have characterized as in a depression with a small ’d,’ has clearly stopped declining as quickly as it once had done.  The maximum rate of decline was December 2008 or January 2009.  Now, the economy is still contracting, but at a slower rate.  The question is: what now?  The general view in the blogosphere is that this is a pause and we will resume our downward path once the true extent of the problems are made manifest.  But, is that really true?

I would argue that it is not axiomatic that the structural problems in the U.S. portend a relapse into a deeper contraction. It is just as possible – actually rather likely in my view – that the U.S. economy, at a minimum, will leave recession within the next 6-9 months, if not sooner. For me, the question is two-fold:

  1. Are we far enough into an improvement in 2nd derivative data (the change in the change of economic data like housing, jobless claims andGDP) that a reversion to deterioration is unlikely?  In plain English, have things have stopped getting worse so quickly for so long that it seems impossible that we could go back to the days when things got worse more quickly?
  2. Do we have the wherewithal to conquer the expected future impediments in commercial property writedowns, credit card writedowns, commercial bankruptcies, and unemployment?

I answer “yes” to both of these questions.  And I hope to demonstrate why more fully in future posts.To date, I have summed up my view in a post called “The Fake Recovery.”  One could actually accuse me of actually fitting the data into my already dark view of the structural problems in the U.S. economy.  However, while this is not what you might term Abby Joseph Cohen optimism, I would say that this view is far enough away from the consensus or my 2008 worries of financial Armageddon that it does represent a more positive tone.

Meanwhile, much of the finance blogosphere is still very much focused on the downside risk. Mind you, I am still concerned about it (one reason you will see ‘doom and gloom’ posts at Credit Writedowns as well), but I am much less concerned than I was just a few months ago.  Count me as a part-time member of the Green Shoots Brigade.

  1. Thomas says

    Personally, I tend to agree with you that we are quite close to the bottom. There may not be a strong recovery anytime soon, but I don’t quite see why the world economy should continue to be in free-fall beyond Q2. Just my two cents based on my very own crystal ball.

    1. Edward Harrison says

      Yes, Thomas, the problem is structural and that means a weak recovery and potential relapse unless these issues are dealt with. My worry is that a recovery, however weak, will be used as an excuse to forget about the structural problems.

  2. Stevie b. says

    Ed – the problem with “general views” is perhaps the conviction with which they are held. People do tend to go with the flow but trying to measure the intensity of that conviction is a whole different matter. Bullish complacency was rife for years before this crash. As a 100% confirmed contrarian based on my experiences over the last near-40 years (I look at one-way streets with a very jaundiced eye…!), I was miles too early in trying to guage when to go against this bullishness – and timing is the crux of contrarianism (charts are really essential). My main question for you is – why should complacent bearishness not last as long as the previous bullishness? Yes, the intensity of the decline may moderate, but why should “the system” not just give false starts & actually continue to implode over time? You are in essence saying “this time it aint different”. I think (gulp!) you may well be wrong.

    1. Edward Harrison says

      Stevie b, I may well be wrong. The key, though, is to address my own biases to, at a minimum, analyze the situation from a more objective standpoint. I tend to think there are deep structural problems which could blow up at any time. So, my bias is probably to the downside.

      Irrespective, as you say, is this time different? I say it is not i.e. “don’t underestimate the power of printing money.”

  3. Stevie b. says

    Ed – made my comment before I saw yours, so I think perhaps you’re glass is only just barely half-full (or should that be half-fool?!)

    1. Edward Harrison says

      Yes, Stevie b. my glass is only barely half full. QE and deficits as far as the eye can see leave me nervous. Until we get through the structural problems, I will be hedged to the downside.

  4. Stevie b. says

    Ed – sorry, postings seem to keep “clashing”. Re printing money: You and I both thought over 6 months ago that we were entering uncharted territory. Yes, now we’re actually in it this could mean upside and sunnier skies, but for me (and perhaps you too) there are still loads more imponderables than “usual” and even though there may be more short-term upside I just don’t like the charts, i.e. the longer-term technical picture.

  5. hbl says

    You highlight an important point regarding confirmation bias. However, in my opinion, the key is to figure out which underlying fundamental dynamics are core and which are secondary, and how far through adjustment those dynamics are. My opinion is that the deflation of asset bubbles (especially residential and CRE) are core dynamics, and that these aren’t done yet (not yet reverted to traditional price/rent, price/income ratios, and huge oversupply now likely to cause overshoot to downside). Another core dynamic is highly fragile balance sheets (e.g., potential for many households underwater on mortgages, corporate bankruptcies, etc) and I have seen no evidence of a way to heal those in the short term. So until I see evidence that policy is able to halt deleveraging or stop correction of asset bubbles, I’m not likely to join the Green Shoots Brigade. But I do hope I get surprised to the upside, maybe I am looking at the wrong things.

    1. Edward Harrison says

      hbl, I agree that the systemic risks and structural and must be addressed. The question is what is the likely path of events if they are and if they are not. I assume that they will NOT be addressed in the U.S..

      One might think that means immediate doom for the U.S. economy. However, I see a Japanese scenario as a particularly compelling model for how things could proceed. And, if you recall, Japan has had spurts of extremely robust growth over the past 20 years since its bubble burst. Nevertheless, its economy has long grown below trend due to its refusal to fix the structural problems.

      While the U.S. does not have the export advantages of the Japanese, it still has other ways of keeping the gravy train going.

      So I am predicting a muddle through scenario for the medium- to long-term i.e. short business cycles, and below par growth.

      In a later post, I will highlight a book by Michael Panzner which gives the Armageddon scenario.

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