So we all think we know how it works, the system. We are all grown-ups, sensible and worldly-wise. Phhat, we know how the system works. Errm, don’t we?
Well, sorry to break it to you but you may think you know how the system works, but do you know how the system really works? Probably not. But there is a man who does.
Roger Martin-Fagg is a behavioural economist, and knowing how the system really works is his meat and drink. Behavioural economists apply all the external psychological factors that influence how we humans process the world, like emotions, culture, society, and use these to better understand how economic decisions are made. So rather than the decision to purchase a house being driven by the basic value judgements of value for money, investment opportunity, growth potential, it is heavily influenced by our psychology and emotions and cultural influences and societal pressures and FOMO etc, etc, you get the picture.
So Roger enlightened the room at the 4thUspire Paradigm Shifter, held in the enthralling location of London Zoo, of how the system really works.
Now behavioural economists sit apart from the mainstream economists. Those guys believe in Economic Man, who base their decisions on rational judgement, this is called System 2 thinking, whereas behavioural economists favour emotional man, who are more instinctive in their decision making, this is called System 1thinking.
What surprised the room was the split between the two systems, with 80% of choices apparently being based on system 1 … emotional man, and this is mostly to do with four psychological traits demonstrated by humans.
Anchoring– we use the first bit of information to make subsequent judgements
Loss Aversion– people value loss 2.5x more than gains
Rule of Thumb– we often apply the rule of thumb which is a rough and ready workable approach based on little or no information
Confirmation bias– we seek out information which confirms our beliefs. Social media is particularly adept at creating groups of like-minded individuals which leads to confirmation bias
Anchoring is a powerful influence on our decision making. The value of something can be set by anchors or imprints in our minds which we use as mental reference points, no matter how arbitrary. Roger pointed out two contemporary anchors which demonstrate this,
“Millennials can’t afford to buy” – this is universally believed and will be a common anchor for many people, however studies do show that housing affordability is now at around 2003 levels, although it may not be a good move to point this out to a cash strapped twenty-something.
“Delight customers to grow shareholder value” – this anchor has been shown to be a key driver of M&A activity, but in reality the two appear to be mutually exclusive – focus on shareholders and customers drift, focus on customers and shareholders drift, an explanation maybe as to why 83% of merger deals did not boost shareholder returns.
All of this led Roger to his first provocation of the afternoon:
Choose a situation where you used system 2 thinking [rational thought] but your boss or the business used system 1[instinctive thought] to make the decision. What would you do differently next time?
So, we can see that emotional man is a key driver of economic behaviour, but what is the state of the current economy and what is the outlook?
It is no surprise to learn that the economy has underperformed since the Brexit referendum. This can be partly explained by the nature of economies – at their heart they are unstable systems. They can, and are, driven by feedback loops, preferably positive feedback. A small change can however be magnified by the systemic effect, and there is no bigger influencer than the media, a major cause of instability. And currently there is a big link between the economy and the political agenda, obviously reported on in the media.
The whole structure of the UK economic system is driven by house prices which in turn dictate the money supply [its complicated but believe me, Roger said so] and when seismic events such as no deal Brexit looms it shocks the system and if sterling collapses, house prices falls, wealth falls, retail sales collapse, banks reduce mortgage lending so money supply dries up, heavy discounting is needed to stimulate retail sales, this impacts on growth and it all revolves around again.
So, the money supply is critical. And Brexit has shocked the system which has led to a reduction in the money supply, which is a key indicator of forward growth. So currently the money supply which the banks hold as tier 1 capital in their balance sheets is sitting at 2%. The target for the banks is 4-5%. And not meaning to scare-monger but before the 2008 financial crisis the tier 1 capital was 1.8%. You do the maths.
The upshot of all this is that unless the money supply picks up soon the next 2 years could be tough, and the UK could be close to recession in 18 months. Don’t shoot the messenger!
Roger now provokes the audience, or you guys sitting at home reading this, to think about to what extent your company is flying blind in the face of the wider macro-economic context?
So, what do companies need to do to ensure continued economic survival? Do they invent or do they innovate? Do they sweat over the blank sheet of paper to invent the new or do they engage in applying an invention, not necessarily their own, to a practical application? Science demands invention but economies demand innovation.
This is best explained by the Kondratieff Long Wave. A theory that suggests a 50-year innovation cycle. After a 25 year period consisting of above trend growth through M&A activity and subsequent decline through cost reduction, the next 25 years are spent trying to claw back to above trend growth as the downswing stimulates companies to innovate out of desperation for new income streams, with the subsequent new markets and new business models triggering the next upswing, starting the M&A activity again.
Innovation is shown to be the life blood of the economy and those that innovate are arguably better positioned to ride the upswing of innovation clusters, and it is predicted that we have another 15 years of innovation. Which brings us to the third provocation, does your company truly innovate or do you buy innovation in? What can you do to create an environment of innovation?
So, what does his mean for leaders? How can this insight be applied? Well, great leaders will use a combination of system 1 and system 2 thinking, switching between the two as the situation demands. They will also be aware of the broader macro situation they are facing and anticipate where possible the impact of cyclical events and economic pressures. And they will encourage innovation; effective revenue-earning innovation that opens markets, creates demand and drives growth.
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