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Who isn’t going to be a millionaire?

17 July 2013

Heath RobinsonJohn Kay has, as so often, an excellent piece in this morning’s Financial Times arguing that statutory obligations of directors in preparing accounts are incompatible with international financial reporting standards (“IFRS”), which require market values to be used in place of traditional historic cost accounting. I shan’t attempt to summarise his excellent points, which you should read directly (if you don’t have access to a copy, visit www.johnkay.com where many of his FT articles appear, including this one).

But I want to reinforce one aspect of his message, when we see the principles of prudence, truth and fairness now being sacrificed on the altar of the efficient market hypothesis, a theory which virtually everyone now accepts is fundamentally wrong. How can this happen?

Sadly the answer is quite simple: it is yet another example of the trahison des clercs, on which I have commented, explicitly or implicitly, throughout this blog (not only in this post). Rather than take responsibility for independent thought, IFRS officials cling onto a dogma which they now know to be at best of limited value simply because they are shielded from personal responsibility if their decisions are wrong. It’s exactly the same reason why doctors are said always to prescribe the standard treatments for terminal illnesses even when they know they will be ineffective, since to follow experimental therapies, even with the patient’s consent, can expose them to legal action.

The prevalence of dogma, and its dominance over individual ratiocination, has numerous ramifications and risks. By suspending personal judgement there is a particular hazard when we pursue a course of conduct that requires a series of decisions: once committed to the dogma, we tend to ignore warning signals that it may be headed in the wrong direction. We are glued to the sat-nav rather than the map, and we follow it into the cul-de-sac or the river long after common sense would have told us the programme had gone wrong.

There are many examples of this in government. As you read this I hope you will provide your own example, since my point is valid even if you don’t like the examples I chose. You might be thinking of major infrastructure projects like HS2, or perhaps economic programmes such as quantitative easing. My example (which many left-leaning exonomists won’t accept) is holding down interest rates artificially low.

But this blog is about cognitive error, not economics. Most of you will at least be aware of a television quiz programme called “Who wants to be a millionaire?” (I’m not sure if the question mark appears in the title; it is certainly redundant in this blatantly rhetorical question.) The contestant is asked a series of a dozen or so questions, all relatively easy (although those on popular culture at the “easiest” levels may well defeat many readers of this blog). You can stop at any stage, but you can only become a millionaire by going to the end. The makers of the programme who make this offer weekly survive financially not because the questions are impossibly difficult, but because contestants underestimate the multiplication of uncertainty. You may have a 90% chance of getting each question right, but after seven questions your survival chances are about even; a few more finish most people off. (I reluctantly spare you an elegant piece of mathematics involving the reciprocal of e: those of you who might understand it will know it already.)

The pursuit of dogma in uncertain fields such as medicine or economics is rather like relying on a Heath Robinson machine where the engineering tolerance of each component is distinctly less than 100%, and the assembly compounds the risk of failure in a calculus few understand.

The ignorance of the public (and indeed of politicians) of the calculus of risk is key to the survival not only of television production companies but of the structured products industry. Mispriced savings products with embedded equity derivatives remain on sale today in spite of all the recent mis-selling scandals. Few if any of our MPs have the slightest idea of standard trading floor concepts – for example, how many would understand that volatility is itself a commodity that can be bought and sold?

As for the interaction of dogma and ignorance, that is a topic for another day.

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