The past 18 months have made all of us students of money, markets and financial policy. If we are, as the saying goes, all economists now, we should consider how to use this new responsibility to help our organizations thrive in financial storms.
Traditionally, we have looked through the economic lens to understand matters such as pricing theory, the forces of supply and demand, and monetary and fiscal policy. This view has assumed that people act rationally, but observation reveals that emotion is a far more potent force underlying business and economic decisions than was previously understood.
I recently spoke at a conference that featured Dr. David Laibson, one of the bright young stars of behavioral economics. Part psychology and part economics, behavioral economics is rapidly becoming a dominant part of economic theory and practice.
During the conference, Laibson reminded us of the famous Solomon Asch experiment in which groups were asked to select two lines of the same length from a larger set. In spite of the fact that the correct answer was obvious to the most casual observer, a remarkable 37 percent of the groups consistently got it wrong. The reason for these mind-boggling errors was the influence of confederates. In every group of six people, five were surreptitiously co-opted by the researcher to give a wrong answer before the unsuspecting sixth subject had a chance to speak. More than a third of the uninformed subjects went along with the obviously wrong answer.
This conformity when all other members of a group seem to agree is what William Whyte, and later Irving Janis, called groupthink. Robert Fritz called it “the path of least resistance,” a mentality that says, “Don’t make waves or look foolishly out of step with the herd.”
Conformity to a norm is one thing when dealing with judgments about the length of lines. It is a more serious issue when dealing with something like an airplane in a critical situation. The National Transportation Safety Board has used voice-recorded interactions between captains and crew members to verify a disastrous effect of this type of inertia. In many fatal aircraft crashes, recordings verify that the crew failed to effectively challenge the pilot even when they knew he was taking the wrong action, such as continuing to search for the cause of a popped circuit breaker while flying the airplane out of fuel.
Researchers conclude that crew members were hesitant to effectively voice their concerns because they felt obligated to defer to a well-established authority precedent. They may have thought, “I know what I see, but I must be wrong because the captain doesn’t see it.”
This problem doesn’t stop with co-pilots. Many of us are trapped by choosing inertia and the desire to look in step with authority figures or with the rest of the world even when they are acting irrationally, dysfunctionally or dangerously.
In September 2007, the world awoke from a sweet economic dream. For too long, there had been excess liquidity in the markets. Lack of prudent lending practices and ineffective oversight led to a flood of risky subprime mortgages. The good times abruptly ended when home mortgage defaults began a meteoric rise, causing a historic retraction in credit and a chain reaction of bankruptcies and layoffs.
The actions that precipitated this shock were based on irrational ideas like: “Housing prices have gone up as long as we can remember, so they will always go up,” “We can always sell defaulted homes for even higher prices” and “Almost all lenders have been making enormous sums of money by offering high-risk loans. I’ll be left behind if I don’t join the herd.”
So now it is Monday morning. We took a beating, and it’s up to you to help your organization learn from this experience and make more rational choices in the days ahead. You might start by ensuring that the teams in your organization give fair hearing to disconfirming information. To avoid groupthink, it is crucial that your leaders create an environment where people feel free to openly challenge conventional views. Many teams find it useful to periodically assign different people to play devil’s advocate. A favorite exercise of mine is to ask a team to identify the kind of circumstances or competitor that could put them out of business.
As Laibson and his colleagues in behavioral economics point out, we only think we are rational. Your challenge is to lead your team to learn from this crisis. Organizations that will thrive in the future must turn a bright light on irrationality and create systems that help their people opt for cogent alternatives. Now it’s time for you to lead the move to rationality.
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