“Phishing” Equilibrium
By: Simon Hungate
Tags: Economy, Society, Robert Schiller, Finance, George Akerlof

“Phishing” Equilibrium

Equilibrium is supposed to be the result of efficient markets, but without regulation, we are constantly “phished for phools”.

George Akerlof and Robert Shiller, both Nobel Prize-winning economists, published a book called Phishing for Phools, which takes a deep dive into how markets often do not offer the best result for individuals, and thus societies because they are forced to focus exclusively on profit motives.

So, let’s take a look at what being Phished for a Phool actually means, and why this concept is important when considering the role governments should play in protecting their citizens. Being Phished for a Phool occurs when, for psychological reasons or due to misleading information, an individual acts in a way that is not in their self-interest. Profit-seeking entrepreneurs and/or business people, often have to exploit these tendencies to make a profit, making them the phisherman and the general population the phools.

Shiller and Akerlof both argue that these scenarios indicate why government intervention is necessary in many situations. A great metaphor they used in their book was comparing business to sports. In sports, players argue with the referee all the time, but I think everyone can agree that in a competitive game, everyone would rather have a ref — otherwise, the team that's willing to deliver the lowest blows will win. Likewise, in business, government regulators are loathed by businesses in certain scenarios, but without regulation, businesses would need to act maliciously to remain competitive. When this is allowed to happen, the market is in ‘phishing equilibrium’- the market is maximizing its profits by getting consumers to do things that are not in their self-interest.

In most cases, phishing for phools is relatively benign, but in some cases, it can put the global economy on the precipice of collapse (ie. Savings and Loans crisis in the 80s, Mortgage-backed securities in the 2000s etc.), and when we consider its prevalence on a broader level, it plays a major role in our general lives.

Phishing for Phools offers many examples of phishing and I’ll outline some of the more practical and extreme examples here (if you want the full 150 pages of examples, I’d encourage you to read the book!).

A great example of phishing is Cinnabon’s: no one actually wants to eat such a fattening, sugary food, but the odor of Cinnabon stores strategically placed in easy to access places (the airport, the subway etc.) are very effective in luring us to buy something that rationally we would not want. This is relatively benign, but many food companies have gone beyond that. Using scientific and statistical analysis, companies are now able to produce their food with amounts of sugar and salt that are proven to make us more likely to buy the food over and over again (this has nothing to do with making the food more delicious). The effect on society is that instead of achieving the most beneficial equilibrium, a phishing equilibrium occurs: too much of these goods are produced, and although people want to be healthy and fit, the additives in unhealthy food make it very hard to shift away from unhealthy foods.

Another interesting example in Phishing for Phools is the use of credit cards. Studies show that individuals who use credit cards are willing to spend more than they are using cash. This is understandable: it is much easier to stomach tapping a card then it is to hand over a wad of cash. Although stores have to pay considerable amounts to credit card companies in transaction fees (sometimes up to 1/5 the store’s profit margin), they do not offer any discount for those who pay with cash. The stores know that consumers will be more willing to spend if they use a card, so they conveniently offer no incentive to pay with cash, choosing to absorb the fees to increase sales.

People don’t want to spend more (especially when most of the US is living paycheque to paycheque), but stores are able to exploit a human trait to get us to spend more than we want. If you or I were to use cash for all our purchases, we’d save considerable amounts of money. It is our choice to use a credit card, and by doing so, without even knowing it, we’ve been phished for phools.

The previous two examples demonstrate the nature of being phished for phools. They are based on psychological factors that are hard to remedy without drastically constraining freedom of choice. But I’ll go over another example of phishing (that I will drastically oversimplify) that was a contributing factor in the buildup toward the great recession and demonstrates the importance of government regulators.

This example is Credit Rating Agencies. Major banks were able to go door to door to each (private) credit rating agency to search out the best rating they could get on the assets they were issuing. They didn’t pay the Credit Rating Agency unless they used the rating, and thus the agencies were competing with one another for business. Needless to say, many assets were horrendously overrated.

A major contributing factor in the incorrect ratings was simply that the agencies had to give good ratings to be in business (also the instruments they were rating were intentionally made incredibly complex by their issuers, making them nearly impossible to accurately assess — we now know a lot of them were junk). Anyone who had bought those securities, taking into account their ratings, had been Phished for a Phool.

The question begs, where were government actors ensuring accurate non-biased ratings? They were nowhere to be found. Since then, under the Dodd-Frank Act, banks must pay rating agencies regardless of whether or not they actually use the rating, which is a simple step that helps to prevent this sort of phishing. This is a great example of how important it is for governments to keep an eye on the circumstances created by profit motives.

Shiller and Akerlof come to a conclusion that seems quite logical: it is very important to have adequately funded government agencies to protect citizens from being phished.

The SEC, for instance, only has one-quarter of a hundredth of a cent for every dollar they oversee. This means that when a company acts fraudulently, the SEC can only go after the corporation and not the individual, meaning they are not a great detractor for financial crime (going after the corporation is much less expensive). Underfunded government agencies like the SEC are certainly a factor that proliferates phishing. Take Bernie Madoff, the creator of a massive Ponzi Scheme — a complaint was filed at the SEC in 2000, but due to underfunding and mismanagement, nothing was uncovered. It took eight years, and millions more dollars phished from the metaphoric sea before he was arrested.

Their key takeaway has nothing to do with capitalism generally, rather they are focused on how to improve markets so that we can move from a Phishing Equilibrium to the actual maximally beneficial equilibrium for society. Without government regulators, profit motives make this impossible to do.

One final note. Regulation should never replace the simple yet crucially important phrase: ‘Caveat Emptor!’