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<p><em>Romesh Vaitilingam interviews Robert Aumann for Vox</em></p>
<p><em>August 2011</em>&nbsp;</p>
<p><em>Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6961]</em></p>
<p><b>Romesh Vaitilingam</b>: &nbsp;Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Professor Robert Aumann of the Hebrew University of Jerusalem and corecipient of the 2005 Nobel Prize in economics.</p>
<p>We met in Lindau, Germany, in late August 2011, at the Fourth Lindau Meeting on Economic Sciences, an event that brought together 17 of the 38 living economics laureates, with nearly 400 top young economists from around the world. We talked about the development of game theory and its potential for understanding conflict, from the Pax Romana to the modern‑day Middle East. But Professor Aumann began by explaining his concept of rule rationality, starting with the work of the 2002 Nobel laureates, Vernon Smith and Daniel Kahneman.</p>
<p><b>Professor Robert Aumann</b>: &nbsp;The '02 Nobel Prize in economics was awarded to two people: Danny Kahneman and Vern Smith. And these two people proved opposite things. Vern Smith proved that people behave in accordance with neoclassical economic theory, and Danny Kahneman proved that people do not behave in accordance with neoclassical economic theory.</p>
<p>You could say, well, did the Nobel committee go crazy in sharing the prize between two people who proved the opposite thing? And the answer is no, because the prize was not given for the conclusions; the prize was given for the methodology. And the methodology is, rather than looking at the real world, your do questionnaires or you do experiments. And as a question arises, how can you get the opposite results, yes?</p>
<p>The answer was given by Tversky and Kahneman themselves, in their original paper in <i>Science</i> in 1974. Widely quoted, that was the opening shot of behavioral economics. The next‑to‑the‑last sentence in that paper &ndash; the paper is called &quot;Heuristics and Biases&quot; &ndash; &quot;These heuristics usually work very well, but sometimes they lead to severe and systematic errors.&quot; And I think that's it. So Vern Smith was talking about the &quot;usually,&quot; Tversky and Kahneman's &quot;usually,&quot; and Tversky and Kahneman themselves were talking about the &quot;sometimes&quot;.</p>
<p>I sum this up in the term &quot;rule rationality.&quot; People do not act consciously to do the best they can, yes? They don't do this consciously. They use rules. They use heuristics. These heuristics are learned, or they are caused by evolution. But usually they work very well. So the rule is optimized. It's not the act, it's the rule. That's the long and short of it.</p>
<p><b>Romesh</b>: &nbsp;How do you think about, then, how that works in practice, in terms of whether people are following the rule or whether they're breaking the rule?</p>
<p><b>Professor Aumann</b>: &nbsp;No, they always follow the rule, only the rule itself doesn't work well sometimes. That's exactly what Tversky and Kahneman says: &quot;These heuristics usually work very well, but sometimes they lead to severe and systematic errors.&quot; They always follow the rule, but sometimes the rule doesn't work, especially in situations which are unusual or unfamiliar. Vern Smith was putting people into market situations, with which they are very familiar. Tversky and Kahneman were putting them into situations which are unfamiliar.</p>
<p><b>Romesh</b>: &nbsp;How does that play out in terms of thinking about the fundamental theories underlying this behavior?</p>
<p><b>Professor Aumann</b>: &nbsp;My work is all based on the idea that people behave rationally. And that is because it's like Friedman said. It's &quot;as if.&quot; The rule makes you behave <i>as if</i> you had consciously maximized.</p>
<p><b>Romesh</b>: &nbsp;Could we think about this in terms of the bumpy period that we're experiencing in the moment?</p>
<p><b>Professor Aumann</b>: &nbsp;All rational. I don't think there was any irrationality in the bump, in the crisis. People acted rationally. They acted in accordance with their incentives. See, Tversky and Kahneman point to situations where people do not act in accordance with their incentives. They act against their incentives. But that's because they're using rules which, in certain situations, go against the incentives. In the crisis, everybody was acting in accordance with the incentives. The incentives have to be changed.</p>
<p>To give you just one example, the institution of credit default swaps. That should be forbidden, in my estimation. You want to make a loan to somebody, make a loan, but you're not allowed to insure it. I'm usually against regulation, and this is interference with the market, but it is, I think, a justified interference. Don't insure your loan. If you insure your loan, you are lessening your incentive to be careful about the loan. You also do something else, which is that you involve the whole rest of the economy in your bad decisions. Firewalls. Every financial institution should make its loans and not be allowed to insure them, because the financial institution that makes the loan, it is the one that understands the nature of the loan the best.</p>
<p><b>Romesh</b>: &nbsp;Can we talk a little bit about your perspective on how game theory made its impact in economics?</p>
<p><b>Professor Aumann</b>: &nbsp;The first big impact of game theory in economics started in the late '50s, with a paper of Martin Shubik, and then in the mid '60s and on into the early '70s. And this was cooperative game theory, specifically nailing down the basis of competitive pricing, the law of supply and demand, and this is based on game‑theoretic situations. The core, the Shapley value, the bargaining set‑‑these are all cooperative‑game‑theory concepts. They all point to the competitive equilibrium, the price equilibrium, in large markets, and they do not point to it in smaller markets. So when you have oligopoly situations, then you do not get price equilibrium. That is well known.</p>
<p>These really provided a framework for economic theory which had been absent before. We observe prices, but where do they come from? This was the big contribution of cooperative game theory to economic theory, which took place for a period of about 15 years, from the late '50s to the mid '70s. Afterwards, we have the tremendous contributions of non‑cooperative game theory, strategic game theory, to economic theory, also to business, to politics, international relations.</p>
<p>By the way, another contribution of the cooperative theory has been to matching markets, hospitals to medical interns, kidney donors. This is Roth, Sotomayor, Gale, and Shapley. By the way, I think the greatest name in game theory, ever, is Lloyd Shapley.</p>
<p><b>Romesh</b>: &nbsp;Tell me about his contribution.</p>
<p><b>Professor Aumann</b>: &nbsp;First of all, he has this concept of the Shapley value. He has the concept of market matching. He has repeated games, dynamic games, stochastic games. All of game theory is full of his contributions. The first prize in game theory should have gone to Lloyd Shapley.</p>
<p><b>Romesh</b>: &nbsp;A lot of the criticism of economics that's come out, particularly since the crisis began, has been the rationality postulate, which you addressed already earlier in our conversation. But another one that noneconomists often say is, &quot;Oh, the subject's way too mathematical.&quot;</p>
<p><b>Professor Aumann</b>: &nbsp;OK, I'll respond to that. It's not too mathematical. You need mathematics to do economics right. I think, over here in Lindau, we are seeing why we need mathematics, because we see people saying things and they're all over the ballpark. You hear one guy saying this; you hear another guy saying the opposite.</p>
<p>They both make convincing arguments. Mathematics keeps you honest. You have to say what your assumptions are, and then you have to prove your conclusions from your assumptions. And the proof has to be correct, of course. And then there's no argument, because you can't argue about assumptions, or, to put it differently, your conclusions. If the person you're talking with buys your assumptions, then he's got to buy your conclusions.</p>
<p>With words, you can prove anything. On the other hand, if you can only do something with mathematics, and you can't afterwards see the intuition for it, then that's worthless. The mathematics is a key to opening the door to whatever insights you can make. But when you go into the room, you have to turn on the light. You have to see what really goes on. If you can just prove it by mathematical formulas, this is worthless.</p>
<p><b>Romesh</b>: &nbsp;Can we talk a little bit about the applications of game theory to some of the big issues? I don't know if these are ones that you particularly like to talk about, but one that springs to mind, and I think you have commented on, is the use of game theory to understand conflict in the Middle East.</p>
<p><b>Professor Aumann</b>: &nbsp;Game theory is maybe too big a word, because you need only very basic concepts. You need the idea that people react to their incentives. The question is, what incentives do you give by your actions? Making gestures or concessions, what incentives do they create? That's the question. I think the answer is obvious: they don't create incentives for peace; they create incentives for war. You don't have to be a game theorist for that. You just have to be an historian.</p>
<p>One‑sided concessions, not negotiated concessions or anything else but one‑side concessions, is a disaster, because it signals weakness and it invites more pressure. History proves it in both ways. History proves it in World War II. An indescribable disaster, yes? And it was brought about by Chamberlain, not by Hitler. Chamberlain cheated Hitler, by signing the Munich Agreement and going back to Parliament and saying, &quot;I have brought with me peace in our time.&quot; What he brought with him was war.</p>
<p>The other side of that coin is what prevented the Cold War from turning into a hot war. I've said this in Stockholm in my Nobel address. What prevented it was that for 40 years, there were airplanes armed with nuclear bombs in the air 24 hours a day, 365 days a year. All the time! In the air! That's what prevented World War III. The right incentives, OK?</p>
<p>One more remark. Two more remarks, actually. There are two big champions of peace in the history of the world. One is these people over there across the lake, the Swiss. OK? They're doing pretty well. And you go to Switzerland to vacation, you see the fighter planes screaming in the air, and they've been at peace for many hundreds of years.</p>
<p>The other big ones were the Romans. Pax Romana. Pax Romana lasted for 400 years. And their proverb was <i>si vis pacem para bellum</i>: &quot;If you want peace, prepare for war.&quot; I'm not saying one shouldn't make concessions. One can make concessions, but not unrequited concessions, not one‑sided concessions. No gestures, no concessions, nothing. Sit down and make an agreement, by all means.</p>
<p>That's what we did with Egypt. Has worked very well up till now. I'm not sure now. It's beginning to be a little shaky, but it's worked very well for well over 30 years. Well, that's what we did with Jordan. There are other references. You have to talk with people who can deliver. You have to be reasonably sure they can deliver. It's a difficult situation we have.</p>