January 12, 2010
LISTEN: mp3 audio (9:08 min)
What’s the connection between an ancient Buddhist word, an economic concept introduced in the late 1960s, and a rock band from Seattle from the late 1980s?
First: the Buddhist word is Nirvana, a Sanskrit term which expresses a transcendent state of bliss, in which pain, suffering and external reality are extinguished.
Second: in 1969, Harold Demsetz, a professor of economics at UCLA, coined a new phrase, the Nirvana Fallacy.
Finally: Nirvana was the name of a Seattle area rock band of the late eighties and early nineties that was known for its “grunge” style of music.
In 1969, Demsetz first used the phrase nirvana fallacy to identify problems in the way government leaders often formulated economic policies and responded to economic events. In a nutshell:
The problem, as Demsetz saw it, was that politicians and public policy makers often viewed their decisions as a choice “between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.”
The commitment to achieving a perfect solution sometimes ignores the realities of life. As an example of nirvana thinking, Sheldon Richmond, writing in the July/August 2009 issue of The Freeman, quotes comments made this summer by a certain unnamed United States Senator on how the government might be able to prevent another financial crisis:
“(We) need a tough, strong regulator, unified – no holes in the system – … who sees the problem ahead of time, so they have complete transparency, they know exactly what’s going on…”
Richmond then asks a question: “How will the regulators know exactly what’s going on?” Further, is it reasonable to expect the regulators will see the problem ahead of time? (Richmond notes that “Fortune-telling is not a widely distributed skill.”) And how can we be sure the regulators are smart enough to know what to do in the event of another crisis? While it might sound like an ideal solution, the senator’s proposal to appoint one or more all-knowing regulators isn’t possible in the real world. No one has access to all the information, and even if they did, no one is smart enough to know how to perfectly apply it. This is an ideal that cannot be attained.
Another problem of Nirvana thinking is that it has a tendency to look backward and assume that what worked best in the past determines what should be the ideal for the future. As a result, Richmond says regulators end up “enforcing formal (possibly outdated and irrelevant) rules, looking for a repeat of the last problem, while missing the next one entirely.”
Nirvana thinking is not only unrealistic, but relying on it can lead to unpleasant consequences. Investors large and small have been burned because they believed that “approved” financial products and institutions were safe. But AAA ratings couldn’t guarantee that some companies wouldn’t go broke. And FINRA licensing didn’t stop some financial companies from running Ponzi scams.
The Nirvana Fallacy isn’t exclusive to government regulators and public policy. The same Nirvana delusions plague economic analysts who believe they can attain a transcendent state of financial bliss by identifying “risk-free” strategies and formulas to guarantee investment profits. The reality is risky financial products cannot be made risk-free. This “ideal” is not a practical reality.
Insurance decisions can also be affected by the Nirvana Fallacy. Usually, buying insurance means allocating money against something unwanted and unlikely – an auto accident, an illness, a disability, etc. If none of those things happen, it’s easy to look backward and say “those premiums were a waste. That money could have been put to a better use than to buy insurance.”
As cars get safer, medicine cures more disease and safety measures diminish accidents, it’s possible to imagine an ideal world where no one is a bad driver, no one gets sick and accidents don’t occur. If that world existed, insurance wouldn’t be needed, right?
Because today’s reality and the future ideal are far enough apart, most people don’t go without insurance. Instead, they just try to minimize the outlay by relying on statistics – which can be another version of the Nirvana Fallacy.
For example: Since statistics indicate the chances of a slim, healthy, non-smoking, safe-driving individual dying before age 60 are very low, it’s seems like the ideal scenario would be to allocate the smallest amount possible to the least amount of life insurance for the shortest time period – because ideally, this person isn’t going to die before life expectancy. The “savings” from spending as little as possible on life insurance could be invested to build an accumulation for the future. Eventually, the size of your savings will eliminate the necessity of “wasting” any more money on life insurance premiums. This application of Nirvana thinking is also known as “buy-term-invest-the-difference.” It is a financial strategy based on the expectation that ideal circumstances will play out – not only regarding whether one lives or dies, but also regarding the performance of the invested savings and that one’s future financial circumstances will be precisely as imagined 20 or 30 years earlier – i.e., there will be continuing good health, continuing employment, etc.
Make comparisons between real alternatives, not just an ideal.
If you understand the issues underlying the Nirvana Fallacy, you should be able to see how it can negatively impact your financial decisions, because you run the risk of pursuing ideals that can’t be realized, or you forgo acting on practical (if less-than-perfect) options.
The best way to reach a long-term objective is to consistently improve the real choices you have right now. Ironically, it is the free market process of gradual adjustment and refinement over time that usually gets us closer to our ideals.
In contrast, making elaborate plans to impose a “new reality” on our circumstances often results in wasted energy, and neglects workable strategies already in place. To turn a phrase and close the connections that began this article, the Nirvana Fallacy often delivers grungy outcomes, not at all what you would expect from a transcendent state of bliss.
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