Mattress Money - Hakuna Matata?

A recent BBC article highlighted the growing trend among Greeks to withdraw their money from banks and, presumably, put it under their mattresses. With confidence in their currency fading fast one can understand why the Greek populous are voting with their money, so to speak. This is an example of risk averse behaviour.

We all have different attitudes towards risk. Some are risk preferring, some risk neutral and some risk averse.

If you had the following choice, which of the two options would you choose?

• A 50% chance of getting £100
• A 100% chance of getting £40

I would hope it would be obvious that the first option has a higher expected value (0.5 times 100 is 50). Despite this, many of us (me included) would choose the certain £40. This is called risk averse behaviour. In our minds the 50% risk of getting nothing is not worth taking.

The Greeks who are withdrawing their cash from banks are exhibiting risk averse behaviour. They would clearly prefer to forgo any interest they could earn from their savings, instead making sure that whatever happens at least they have some money.

It's commonly accepted among economists that people are often relatively risk-averse, and thus good economic models account for this type of behaviour. Risk aversion is not bad, indeed, we could do with bankers taking fewer risks at the moment! The level of risk aversion will depend upon the exact situation. For example, if I had already given you £500 before giving you the above choice, you may have been more likely to take the risk (any economists out there will recognise this as the income effect).

In conclusion, mattress money is a prime example of risk aversion. I wonder, if you were Greek right now, would you be happier sleeping on your life savings or entrusting it all to the banks?

Recommended listening:
Hakuna Matata

Rules Of Thumb - Superstition

My parents recently went on a short trip to a Eurozone country (for those reading this in the future, the Euro was the currency which collapsed thus causing the Second Great Depression). My advice beforehand was to take Dollars or things you can easily barter (jewellery or livestock), but in the end they went with Euros rather than greenbacks, earings and chickens.

Upon their return I aksed my mum what the exchange rate was, only to hear the reply that she didn't know exactly, but she thought of it as "about £1 to €1". This is a rule of thumb. It is also clearly wrong (actually about £1 to €1.2, as of the 11th June 2012). However, people are constantly using similar (incorrect) rules of thumb in their everyday lives. So why do we do it?

http://cdn.theatlantic.com/static/mt/assets/steve_clemons/euro1.jpg

Well, while the diference between €1 and €1.2 per pound might be life or death for a currency trader, it is close enough for an ordinary person. It's a very easy way to remember a potentially complex ratio. And frankly my dad may well have been pleased this rule of thumb was in operation, as if anything the 'adverse' effect would only to have made things look more expensive than they really are, thus reducing purchases!

Two famous psychologists called Amos Tversky and Danny Kahneman famously coined the term 'heuristics' to describe rules of thumb, and show that they can occassionally lead us into serious errors. All of this is a challenge to traditional economic theory which assumes that we are rational beings that don't need to resort to crude rules of thumb to solve everyday problems. An important part of behavioural economics over the last 40 years has been the attempt to explain how exactly we use rules of thumb, and therefore how they need to be incorporated into our big important economic models.

Recommended listening:
Superstition by Stevie Wonder