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15th JEEA-Fundación BBVA Lecture

Ulrike Malmendier explains how the COVID-19 crisis will discourage entrepreneurship and promote excess savings through the workings of the “experience effect”

Juan Pujol

Professor Ulrike Malmendier has delivered the 15th JEEA-Fundación BBVA lecture, which was held online and streamed live. Her prediction on Spain’s post-COVID crisis is that it will especially affect employment choices, which will prioritize stability over self-employment, and consumption, generating a trend that favors saving over spending: “Young people will think that crises are an everyday occurrence”.

29 October, 2020

Traditional economic models explain the decision-making process by reference to monetary or financial variables like incentives, losses or profits. A kind of snapshot of an individual or firm (income, wealth, employment, education, or, in a firm’s case, size, industry, business model…), taken at one point in time, which the model projects into the future as if they were perfect twins bound to perform the same whatever the circumstances. Prof. Ulrike Malmendier is unconvinced: “What the concept of experience effect says is that this is not true.” Instead there is an “indelible memory” of the experiences of the past that lingers on in individuals and influences their decisions.

“Looking at the past and what people have gone through, their crises or successes, has really strong predictive power for their future decisions. It is not just, as economists think right now, because an experience of failure makes you poorer. What happens is that people act as if the key scenarios they have lived through (the COVID-19 crisis, the Great Depression, the ’29 Crash…) are particularly likely to happen again.”

Ulrike Malmendier has delivered the 2020 JEEA-Fundación BBVA Lecture with the title “How Experience Effects Bias Decision-Making, Even Among Experts.” “I am not saying – in reference to such experts – that the manager of the firm is incapable of grasping the situation or judging the probabilities. We are talking about very sophisticated, highly educated people. What I am saying is that people get rewired.  Our brain gets rewired by past experiences and when something similar comes up, that’s what our brain immediately goes to, and we give more weight to that scenario compared to someone who hasn’t shared it.”

To illustrate her point, the Professor of Economics and Finance at the University of California, Berkeley gives an example from a recent paper, (“The Making of Hawks and Doves,” Malmendier, Nagel, Yane, 2020), which applies econometric analysis to a long time series of the decisions of the U.S. Federal Reserve’s Open Market Committee (whose members traditionally split into hawks and doves) over the second half of the 20th century. At its center is Henry Wallich, Federal Reserve governor from 1974 to 1986, who was born into a banking family in Germany in 1914, and before emigrating to America had lived through the German hyperinflation of the 1920s.

To this day, Wallich holds the record for the greatest number of dissenting votes on the FED committee, in most cases alluding to the central bank’s special duty to combat high inflation, while advocating larger interest rate hikes. “This happened decades after his birth in a different country to a highly educated, trained economist with access to all possible information… In this respect, I would say that the experience effect can outweigh information, expertise and context. It is amazingly powerful,” says Prof. Malmendier.

Crises as a fact of life

Prof. Malmendier’s research suggests that living through successive crisis periods can mark people in important ways. Young people in their 20s, for instance, have endured first the Great Recession and now the COVID-19 crisis, whose effects seem certain to be lasting: “These individuals will tend to act as if a crisis were really likely to happen again, because that is what they have seen in their lives. And they will adjust their behavior and their decisions accordingly. The current crisis, for instance, will mean drastically worsened job opportunities. In the United States it’s the young generations who are affected most strongly. I also know that in Spain, even before this, young people have faced serious difficulties accessing the labor market.”

For her, an important touchstone is the experience of the U.S. following the Great Depression, a time when less skilled, more boring but safer clerical jobs became the preferred option in a labor market at other times favorable to riskier entrepreneurial or managerial options: “My prediction – she continues – is that something similar will occur in Spain. It will affect how people think, for example, about the trade-off between a job and staying at home; it will affect entrepreneurship, in that there will be fewer new ideas appearing because there will be more aversion to the risk involved in starting a business. And then there is consumption. My studies show that if you have lived through a crisis with high unemployment in your youth, even years later, when you are forty or fifty with a stable job, you will still save a lot more than a person who hasn’t had this bad experience.”

Prof. Malmendier is familiar with at least one other aspect of Spain’s economic life, the importance of real estate. In another of her papers, (“Rent or Buy? The Role of Lifetime Experiences of Macroeconomic Shocks within and across Countries,” Malmendier, Steiny, 2016) she concludes that Spain has undergone an accumulated experience effect: “There is even a graph in which Spain features prominently, with a particularly high ratio of home ownership, at around 90 percent. If you look across the European Union, it is amazing how you have countries like Austria or Germany with around 50 percent ownership and then Spain with above 90. Sure there are country-specific differences, but even if you think about geography, neighboring France is somewhere in the 60s.”

What Malmendier and her co-author did was compare home ownership with how inflation has evolved in the last 40 years. In almost all cases, it turned out that the countries with the highest home ownership were those that had experienced higher inflation rates. “So I do think that it plays a direct role. Also, thanks to this data, the ECB has been collecting EU-wide consumer information to study the phenomenon.”

For this reason, Malmendier believes it is “important for policy makers to be aware that there is an accumulated experience effect that can’t just be switched on or off. It can take decades to change the way consumers behave.”

Simulation as a learning tool

The question of how to reverse a trend driven by years of accumulated experience is one that fascinates Prof. Malmendier: “You can’t just say let’s educate people by explaining the problem well. That won’t work. What we have to do is find ways to simulate experiences. Take the stock market for instance. If you go to the bank, and say I want to invest, the first thing they’ll ask is how risk averse are you? That’s something we don’t necessarily know about ourselves. It would be much more effective if they said let’s play an investment game. We invest it this way and look at how the portfolio would perform in different scenarios or taking different decisions.”

One of her students has been running an experiment with farmers in rural China, focused on a cheap state-sponsored insurance policy that almost no one was taking up. “So they played an insurance game, simulating what would happen if disaster did or didn’t strike and what would happen to their money if they had the insurance or not… the experiment wasn’t perfect but it had a much larger effect than just telling them about it.” The next step? “I am trying to set a similar thing up with some financial institutions, because I am convinced it could work well. It’s not proving easy, but I have high hopes.”

Malmendier, who also has a PhD in law, likes to draw in her research on other knowledge areas like neuroscience or psychology. She describes her own expert field – behavioral economics – as “the way (people) systematically deviate from rational decisions.” And from her frequent references to “neo-classical economists” or “standard economic models,” it seems safe to say that she often starts from less than orthodox positions.

Another of her best known papers from the mid-2000s was “Paying Not to Go to the Gym”, in which she described how gym members fall repeatedly into the trap of thinking that paying a monthly fee will work out better than paying per visit. And this despite knowing from experience that they don’t attend enough times to justify the monthly price. “It’s not the case that we do it once by mistake, then realize our error and correct it,” she points out. “What people found so puzzling about this paper was that we do this consistently.” Some academics argued that, after three or four times, surely users must learn the lesson and switch to pay-per-visit: “They said my model wasn’t allowing for the consumer’s learning curve, that at some point ‘rational forces’ must win out … But that is not necessarily the case. Again, we are wired that way, we have these good intentions and see ourselves doing things to improve our health and physical appearance.”

Ulrike Malmendier bio notes

Ulrike Malmendier – Edward J. and Mollie Arnold Professor of Economics at the University of California, Berkeley – is one of the top financial scholars in academia. She won the prestigious Fischer Black Prize from the American Finance Association for the best finance researcher under 40 in 2013, which noted the originality and creativity of her research in corporate finance, behavioral economics and finance, contract theory, and the history of the firm. She has been teaching in UC Berkeley’s Department of Economics since 2006 and holds joint professorships in economics and business at Berkeley, where she is the founding co-chair of the Initiative in Behavioral Finance and Economics.

Malmendier’s research lies at the intersection of economics and finance, specifically how individuals make mistakes and systematically biased decisions. Her work includes research on CEO overconfidence, the long-term frugality of “Depression babies”, and the decision-making behind gym membership. She has recently become interested in the impact of economic shocks, such as high inflation or unemployment, on the later economic behavior of individuals who lived through these periods.

Malmendier was inducted into the American Academy of Arts and Sciences in 2016.  She is a founding board member of AFFECT, the AFA’s American Female Finance Committee, serves on various academic boards, and is frequently asked to give keynote addresses.

Prior to UC Berkeley, she was an Assistant Professor of Finance at the Stanford Graduate School of Business and had visiting positions at Princeton University and the University of Chicago Booth School of Business. In addition to teaching, she has conducted extensive research for the National Bureau of Economic Research (NBER), Centre for Economic Policy Research (CEPR), Institute for the Study of Labor (IZA) and CESifo (Center for Economic Studies ifo Institute) in Germany. She is a founder and co-organizer of BEAM and SITE Psychology & Economics, the leading conferences in behavioral economics. Malmendier received her PhD in Business Economics from Harvard University in 2002, and her PhD in Law from the University of Bonn in 2000.

JEEA-Fundación BBVA lecture

The BBVA Foundation supports the generation of knowledge and its transmission to society in the socio-economic field through its own programs and in conjunction with leading institutions. Since 2005, the Foundation has hosted the annual JEEA-FBBVA Lecture in partnership with the European Economic Association (EAA). This international scientific body promotes the development of economic science throughout Europe, as well as communication between teachers, researchers and students, the links between university and research centers and relations between theoretical economists and policy-oriented economists.

The JEEA (Journal of the European Economic Association) is one of the leading scholarly publications in the field, known for the high scientific quality of the articles it carries and the prestige of its collaborating editors. Since 2017, publisher Oxford University Press has brought out six issues each year, one of which contains the text of the JEEA-FBBVA lecture.