His "Prospect Theory" suggests that people's degree of pleasure
depends more on their own subjective experience, than on objective
reality.
Professor Kahneman was recently honored at Israel's Ben Gurion
University. His lecture started us thinking as to how psychology
affects Israelis' attitudes towards this country's economic
prospects. How often do we hear the cantankerous sounds of people
holding diametrically opposite points of view.
Recently the influential Business Week wrote: "Something is afoot in
Israel's financial markets. The leading Tel Aviv stock index is up
34% so far this year. Since reaching this level it has retreated by
several percentage points. After unable to raise money on the
international capital markets for more than two years, the Israeli
government recently attracted institutional investors to a commercial
bond offering, raising $750 million".
Prof. Kahneman's reaction might likely be: "If the market starts
rising, that rise in some sense expresses a better mood, but it also
causes a lot of people to become more optimistic". Prof. Kahneman's
Prospect theory helps explain biases of beliefs such as "optimistic
overconfidence" -- whereby people believe they can do, what in fact
they cannot do. When you have a situation where everybody believes
they are above average, the markets are going to behave in a funny
way".
Yet any high school student will tell you if asked, that the Israeli
economy is likely to grow less than 1% this year.
The country's gross domestic product that droppped 3.8 percent in
2002 is headed for an additional drop. The intifada's cost to
Israel's economy has been estimated by the Bank of Israel at $4
billion. Income has shrunk and the Central Bureau of Statistics
reports that unemployment soared to 10.3 percent, close to the
highest figure in Israel's history. So far this trend has not been
reversed. The conclusion may be drawn that the Israeli public is
exhibiting a strong dose of "optimistic overconfidence"
So what is to be expected for the rest 2003 and beyond? We view the
future with a "a measured touch of pessimism capping our basic
optimism".
The geopolitical situation that prevailed in the Middle East since
Israel's inception, precluded trade between Israel and its
neighbors. Furthermore, the quality and structure of Israel's
industrial production made Europe and the US natural trading
partners for Israel. In 2002, the US and the EU accounted for 31% and
30%, respectively, of Israel's exports and for 22% and 40% of its
imports. Our guess is if the American economy picks up next year it
will have a highly positive impact on Israel's high tech exports and
the economy as a whole. The dependence of Israel's industrial exports
on American demand should not be overlooked.
The export-driven hi-tech sectors are affected primarily by external
demand, and tend to be less sensitive to geo-political events.
Exports should not be affected even if the Middle East politics
worsen, which is not expected.
The negative investment climate, a a product of perceived
instability, resulted in a decrease in Foreign Direct Investment in
2002. FDI to Israel is still high when compared to investment in
other industrial nations. Average inflows of non-EU FDI to the EU (as
percentage of GDP), for example, were lower than those for Israel.
2002 figures indicate a sharper decline in FDI inflows, a trend that
may be reversing, following the war against Iraq. Foreign investors
are already expressing optimism in the economy. In the first five
months of 2003, the securities portfolio of foreign investors in
TASE-traded stocks rose to $1 billion. Foreign interest in the
private equity market is also on the rise, as the second quarter of
2003 saw an increase in the participation of foreign venture capital
in financing Israeli start-ups.
We do not expect the Intifada to resume though the period ahead will
likely be marked by tensions and threats of a return to widespread
terrorist violence. What could upset the applecart would be the
enalrgement of the scope of the most recent sporadic acts of terror.
The Israelis' indominable will to carry on even in the face of lethal
suicide bomber attacks makes the restart of the Intifada an
unprofitable policy. But the unprofitability of bad policies has
never deterred the Arab world from rash actions.
Israel's Finance Minister Benjamin Netanyahu, argues that one key
reason smart money is heading to Israel is the government's radical
program to liberalize its economy. In three months, Israel has pushed
through massive reductions in state spending, including the
first-ever cut in public-sector wages. Income tax rates will be cut.
The planned cut in taxes is similar to that enacted by President
George Bush that its intent is to put more spending money in the
pockets of the citizens.
Fundamentally, we do not disagree with the Finance Minister's
optimism, but we worry a bit whether it includes a measure of
"optimistic overconfidence".
"Israel has the greatest concentration of people capable of producing
conceptual products -- value-added products -- in the world. There
are only two economies that have that capacity. Ours is the most
concentrated, even though it's a lot smaller than that of the U.S. I
claim that everything in Israel is undervalued. A $16,000 per capita
income is ridiculous for a country like Israel. It should be around
$40,000". Our only concern is that the time span required for the
return of prosperity be as short as possible.
As global economies wobble and international stock markets shake
they continue to defy comprehension, economists are turning to Nobel
winner psychologist Daniel Kahneman for his incisive insights
related to psychology. The Israeli/American Princeton University
professor is known for research conclusions indicating the effects of
economics to quirks in human behavior. Among these is the tendency to
be overconfident or avoid risk. This, asserts the Professor, may
lead to investor decisions that don't always bring the best, or most
logical, outcomes.