Why Negotiations Are So Hard

Say I offer you a 50/50 chance to either win $200 or lose $150.  Would you take that chance?

Most people wouldn't.

But, from a purely mathematical standpoint, it is a good bet.  That chance has an overall value of $25 (.5*200 - .5*150).  Many experiments have been done on such gambles and the result is that people only start to take the chance when the gain is about double the loss (win $300 or lose $150).

Now, a purely rational agent would take any chance that has a value greater than 0.  So these experiments have shown that in the case of these gambles, people are not acting as rational agents.  Indeed, the conclusion is that the emotional impact of a loss is about twice that of a gain of the same amount.  

If you think back to your own experiences with gains and losses, you may recall feeling the same way.  But the implications are very interesting.

This is what makes negotiations hard.  A negotiation is, basically, one side giving up something in exchange for the other side giving up something.  But if we value losses twice as much as gains (and the other side is doing the same thing), we can understand why it's so hard to come to an agreement:

We think our giving up X has a value of $1000, but the other side only sees it as a gain of $500.  Making it worse, because it's a loss worth $1000 to us, we ask them to give up something that we think has a value of $1000, but they see it as a loss of $2000.  

The psychology of this can be seen everywhere.  In battles, the defending army fights harder than the invading army.  You can even see this in gas prices.  Back when there were discussions as to whether to allow cash and credit gas prices to be different, the credit card companies said that if there was a difference, it should be called a cash discount rather than a credit surcharge.  The reason is that people would rather forego a discount (gain) than pay a surcharge (loss).  The numbers are the same, and to a rational agent, it would be equivalent.  But to people, it makes a difference.

This is a clear case in which our emotions cloud our better judgement... as usual.  So what can we do about it?

Actually, it's not so hard to fix our thinking.  Let's go back to the gamble above.  What if, rather than giving you one chance at winning $200 or losing $150, I gave you a hundred chances?  You would likely quickly reason that the overall odds would be in your favor and its very likely you would end up with a winning (greater than 0) amount.  But, really, it's the same gamble - just repeated a hundred times in the latter case.

In other words, taking a broader view helped you realize that is a good bet.  In the grand scheme of things, the few losses here and there would be outweighed by the wins.  When faced with any decision like this, we can apply the same logic.

The negotiation situation is not terribly different.  If we can take a broad view and look holistically at everything we will be gaining and losing during the negotiation, we realize that a single loss doesn't hurt so bad.    

This is just one of the themes discussed by Daniel Kahneman in his excellent, if dry, tome: Thinking, Fast and Slow:

http://www.amazon.com/Thinking-Fast-Slow-Daniel-Kahneman/dp/0374275637

Why Everything We Do to Motivate People Is Wrong

There is a mismatch between what science knows and what business does.  I mentioned this some time ago in this post:

http://onexerxes.blogspot.com/2010/06/money-doesnt-motivate-people.html

Basically the point is that for sophisticated tasks, money doesn't motivate people.  Actually, any extrinsic rewards do not motivate people.  You need intrinsic motivation.  Dan Pink puts it really well in the below video, quoting my favorite behavioral economist, Dan Ariely:

Spain Is Too Big to Fail - But It Will

There has been a lot of focus on Greece's financial state lately.  And rightly so, because its total debt (including unfunded liabilities) is about 11 times its GDP.

But, realistically, Greece's economy has never added much value to the European Union.  The EU had a GDP of about 12 trillion euro in 2010.  Greece only contributed 230 billion euro, or less than 2%.

Spain, however, is the weakest of the big contributors.  Its GDP was 1.6 trillion, or 13% of the EU.  And Spain has debt and unfunded liabilities totaling 6 times its GDP.

To put things in perspective, the US had debt equal to about 2 times its GDP in 1929... and we all know it took the Great Depression to unwind that debt.

So what's the point?  Spain will default.  And its economy is too big for the EU to save it.

In fact, its key index is already poised for a crash.  Notice the head and shoulders pattern in the IBEX:

Spain will likely trigger the EU collapse.  And that will then trigger a global collapse.  After all, US debt is currently 8 times its GDP:

Yep.

Boomerang: Travels in the New Third World

After The Big Short, I decided I liked reading Michael Lewis.  So I read his latest.  What is the new Third World?

Europe.

In Boomerang, Lewis tours the countries most decimated (so far) by the current debt crisis.  It's not that he makes light of their plights, but he does frame them within the context of their national identities:

The tsunami of cheap credit that rolled across the planet between 2002 and 2008 was more than a simple financial phenomenon: it was temptation, offering entire societies the chance to reveal aspects of their characters they could not normally afford to indulge.

Icelanders wanted to stop fishing and become investment bankers. The Greeks wanted to turn their country into a piñata stuffed with cash and allow as many citizens as possible to take a whack at it. The Germans wanted to be even more German; the Irish wanted to stop being Irish.

Michael Lewis's investigation of bubbles beyond our shores is so brilliantly, sadly hilarious that it leads the American reader to a comfortable complacency: oh, those foolish foreigners. But when he turns a merciless eye on California and Washington, DC, we see that the narrative is a trap baited with humor, and we understand the reckoning that awaits the greatest and greediest of debtor nations.


Edit: This stuff is real:
http://www.bbc.co.uk/news/magazine-16472310

The Big Short: Inside the Doomsday Machine

Another excellent book.  In it, Michael Lewis follows a handful of investors who foresaw the bursting of the subprime mortgage bond bubble.  They made massive bets on the collapse of the financial system that nearly brought the world to a halt in 2008.  Of course, they made tens of millions of dollars each during that crisis.

While the narrative is certainly sapid, the most salient point is made in the epilogue: the financial system is still broken.  Maybe these few investors were vultures in making obscene amounts of money betting on a collapse, but the bigger problem is that no real measures were taken to prevent such a collapse in the future.  The US government just threw money at the problem to make it appear to go away.  No lessons were learned.

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.  - Upton Sinclair

A collapse will happen again.  Maybe something else will trigger it next time.  But in one way or another, greed will rear its ugly head.  With a vengeance.

It [More] Begins

Something just occurred to me.  Let's look at some facts:

The cost of rebuilding Japan is at least $309 Billion
The vast majority of Japan's currency reserves are in US Treasury Bonds
The US Government's AAA rating is now being questioned by Standard and Poor

In other words, Japan needs its money back.  And now one of the most respected rating agencies is casting doubt on the US Government's ability to pay back its bond-holders.  What better time to cash them in?

If this does indeed happen, it will be like the few small pebbles that trigger an avalanche:

Time 0: Japan redeems some US Treasury Bonds
Time 0: Ipso facto, Japan stops buying US Treasury Bonds
Time 1: With this loss, the US economy becomes even weaker
Time 2: Other nations (read: China) likewise question the safety of their investment and pull out
Time 3: Go to Time 1 and repeat

As a side note, when the populace loses faith in fiat currency, gold and silver skyrocket.  Is this happening?

You better believe it.

Where is this going?  I'm officially calling Dow 4000 within 2 years.

It Begins

The BRICS have just decided to drop the US Dollar when issuing credit to each other.

The group holds 40% of the world's currency reserves.  So this is a big hit to the dollar.

But this is just the beginning.  As I've said before (and keep saying), it is going to get a whole lot worse.

The Fall of Keynesianism

Those of you who know me also know that I think the world economy is going to collapse soon.  It will start with the US.  Here's a peek at the current US debt.  Notice the amounts owed by every single taxpayer, especially at the lower right:

http://usdebtclock.org/

It will get the point where the US won't even be able to pay the interest on the money it owes.  And that $14 trillion figure doesn't even take into account private, business, and especially financial sector debt.  All of these total over $100 trillion.  Unsustainable.  And when the camel's back breaks, it will take the liquidity of the world down with it.

It will be, quite literally, insanity.   

This is of course a highly charged idea, and I don't want to get involved in the politics of it... at least not yet.  But I saw this great quote today that I just had to share:

The first lesson of economics is that we live in a world of scarcity. There is never enough of anything to satisfy all those who want it. The first lesson of politics is to ignore the first lesson of economics.

— Thomas Sowell

Enough said.