Financial Analysts Journal Book Review

Phishing for Phools

The Economics of Manipulation and Deception (a review)

  1. Lisa R. Goldberg
The “invisible hand” of the free market can hurt as well as help participants. The authors, who are Nobel Prize–winning economists, argue that as long as there is profit to be made, sellers will exploit our psychological and behavioral weaknesses through manipulation and deception.

In real life, people differ from the rational agents described in economics textbooks. We may consume super-sized soft drinks that make us fat. We may increase our risk of an early, expensive, and gruesome death by smoking cigarettes. Rife with overconfidence, we may buy lottery tickets and invest in hedge funds. In the face of copious and explicit information about how we deviate from rationality, ranging from such scholarly works as Daniel Kahneman and Amos Tversky’s “Prospect Theory” (Econometrica 1979) to such popular treatises as Kahneman’s Thinking, Fast and Slow and Jonathan Haidt’s The Righteous Mind, we human beings persist in making choices that are not aligned with our best interests.

In Phishing for Phools, a collection of stories about profit from deception, Nobel Laureates George Akerlof and Robert Shiller discuss the effects of so-called irrational human behavior on financial markets. They explain that in the absence of regulation, someone will always be willing to exploit our irrational tendencies, leading to a “phishing equilibrium” in which individuals are harmed. Akerlof and Shiller argue that we can do better.

According to Wikipedia, phishing is an attempt to acquire sensitive information by a malicious online entity masquerading as a friend, and the term dates back at least to a 1987 presentation to INTEREX, the International Association of Hewlett-Packard Computer Users. Early phishing expeditions include a 1995 attempt to acquire passwords and credit card information from AOL users with a program called “AOHell.” In the book, the term “phishing” is co-opted from its standard use to refer to “contemporary fraud.”

Akerlof and Shiller tell how Goldman Sachs mined its reputation as a “trusted friend” to sell highly rated but worthless securities to clients in the run-up to the financial crisis. They describe the deceitful accounting that led to the US savings and loan crisis in the late 1980s and early 1990s. They also recount how pharmaceutical giant Merck fell from grace by ignoring an internal memorandum showing that its “miracle drug” Vioxx caused heart attacks.

The authors contend that sound government regulation has protected us from fraud in the past, but a currently popular “new story,” in which government regulation is bad, neglects this part of history. This idea is supported by Jane Mayer’s book Dark Money, which documents how right-wing and libertarian organizations backed by corporations and billionaires have actively promoted this “new story.”

In the “old story” that emerged after the Great Depression and World War II, Akerlof and Shiller note that “government could be a useful counterweight to the excesses of free markets.” They point to Social Security, signed into law by President Franklin D. Roosevelt in 1935. Using free-market “new story” rhetoric, the George W. Bush administration attempted to introduce individual, self-managed accounts into Social Security in the mid-2000s. Would such a system have promoted our best interests? Based on historical simulations detailed in Shiller’s 2005 article “The Life-Cycle Personal Accounts Proposal for Social Security: An Evaluation,” the authors conclude that increasing investors’ freedom to manage their Social Security allotments would likely have been disastrous.

Phishing for Phools contains useful insights for all types of financial market participants. For an individual investor, the message is caveat emptor. Investment professionals might consider the importance of alerting clients to market pitfalls. Finance scholars may find motivation to develop behavioral models that are as influential as the rational models. In the best case, Phishing for Phools could help to revive the “old story” in which government regulation can elevate the common good.

Despite the book’s strengths, the authors sometimes exercise poor judgment about what to say and what not to say. Many of the stories are hard to follow, and at least one is in poor taste. To illustrate how newscasters and advertisers command our attention, Akerlof and Shiller describe the 2013 mysterious disappearance of Malaysian Airlines Flight 370 as “inconsequential-in-the-grand-scheme-of-things.” I wish this book had been edited more thoroughly.

According to free market economics, individuals promote the common good by pursuing their selfish interests. In this setting, the self-interested individuals are rational agents, and promoting the common good is the work of Adam Smith’s “invisible hand”:

He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

The first fundamental theorem of welfare economics formalizes the invisible hand concept. It says that free markets lead to a Pareto optimal equilibrium, in which no individual can be made better off without another being made worse off. This equilibrium lies at the heart of the argument for deregulation.

How do we create effective and sustainable regulation that protects us from fraud without limiting our liberty? Answering this question is difficult because human behavior is messy, and Phishing for Phools does not provide an answer. Instead, the authors suggest that we need a behavioral analog to the concise, powerful quantitative models that underlie rational economics. With a behavioral equilibrium at the heart of a “fundamental theorem of welfare economics for human beings,” we might, at last, be able to enact regulation that prevents financial markets from spinning out of control.


“This crisis has reminded us that without a watchful eye, the market can spin out of control.” — President Barack Obama, 2009 Inaugural Address

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