Behavioural Economics

by padraigcolman

I had this article published in The Island newspaper on October 31 2008

In the run-up to the US presidential election, commentators are wondering what kind of economic policy Barack Obama might pursue. He taught at the University of Chicago but that does not mean that he is of the Chicago school of Milton Friedman. Obama is not a doctrinaire monetarist.

There is a new Chicago school. Behavioural economics combines the insights of psychology with the rigour of economics, factoring human unpredictability into market analysis. This centre ground between the Friedmanites and the Keynesians appeals to politicians.

Richard Thaler teaches at the University Of Chicago Graduate School Of Business and is close to Austan Goolsbee, Obama’s economic advisor. Thaler wrote a column called Anomalies (sometimes in collaboration with Daniel Kahneman, the first psychologist to win the Nobel Prize for economics) in which he described economic behaviour that did not fit in with the accepted norms of economic theory. Anomalies showed how, in reality, homo economicus failed to pursue his own self-interest. Decisions were based on received wisdom or bizarre rules of thumb rather than logic.

Thaler has collaborated with Cass R Sunstein on a book called Nudge: Improving Decisions about Health, Wealth, and Happiness. Sunstein was for ten years a colleague of Obama’s at the University of Chicago Law School (he is also affianced to Professor Samantha Power, who was Obama’s foreign policy adviser until she resigned after calling Hillary Clinton a ‘monster’).

“People often make poor choices – and look back at them with bafflement!” Thaler and Sunstein write in Nudge. “We do this because as human beings, we all are susceptible to a wide array of routine biases that can lead to an equally wide array of embarrassing blunders in education, personal finance, health care, mortgages and credit cards, happiness, and even the planet itself.”

Dan Ariely of MIT, author of a bestselling book Predictably Irrational, describes an experiment where customers were thrown into confusion by an abundance of choice. “Jams are hardly complex things, but people saw 24 stacked together and thought: ‘I have no idea how to deal with this.'”

Markets go haywire when the choice is more complicated than buying jam. The world-wide credit crunch following the sub-prime mortgage fiasco is a recent example. The followers of John Maynard Keynes would want tight regulation and prohibition of excessive borrowing. To the followers of Milton Friedman any interference with market forces would be anathema. Behaviouralists argue that a gentle nudge works. Behaviouralists tend to be more hopeful than Keynesians about redeeming free enterprise.

In the eighties, UK orthodoxy was to force people to take responsibility for their own pensions. Now most will be automatically enrolled in a retirement-savings scheme. They can opt out, but the inertia that stopped them taking up a pension plan will keep them in. George Osborne, who would doubtless take over from the hapless Alistair Darling as Chancellor of the Exchequer if there were to be a UK general election today, is a believer in ‘libertarian paternalism’ and the PM himself (at the time of writing, Gordon Brown) has expressed an interest in Sunstein’s concept of ‘presumed consent’.

The customer is king but what if the king is confused? Is the customer an emperor with no clothes, no sense, no savings, and huge debts accrued against the security of property that is now plummeting in value? Daniel Gilbert and Tim Wilson have coined the term ‘miswanting’. Dramatic increases in consumption failed to lift the collective mood. George W Bush’s instinctive response to 9/11 was to command the American people to go out and shop for their nation as the best way to defend it against the infidel. The result has been worldwide recession.

Britain is stricken with pleonexia – destructive consumerism. Binge drinking has become the main national sport and alcohol-related deaths continue to rise. The overall death-rate from alcohol has almost doubled from 6.9 deaths per 100,000 people in 1991 to 13.4 in 2006. Dr Christopher Record, a liver disease consultant says “Alcohol now is 50% less expensive than it was 25 years ago and, needless to say, consumption has gone up by 50% pro rata.”

The Economist’s columnist, Bagehot, suspects that the theories of behavioural economists appeal to politicians because they provide a cover for a hands-off approach to problems they should be facing head-on. “Nasty behaviour—such as the propensity of some British teenagers to drink too much, get pregnant or stab each other—is often symptomatic of a deeper malaise: skewed values, social atomism, despair and so on.” Problems of this kind might require the smack of firm governance, rather than a gentle nudge, but the term “nanny state” has long been part of the dictionary of political abuse.

From the perspective of behavioral economics, the key factors are inertia, overconfidence, and loss aversion. In their everyday existences, people tend to stick with what they are doing, even if trying something different wouldn’t be difficult.

Behavioural economists have taught politicians and policy-makers that the ‘invisible hand’ of the market is not infallible. Their theories and experiments are of interest to politicians because of their relevance to decisions in the public sphere – whether to grant patients buying power in the health service, whether to compel individuals to save for their old age. They also have relevance to business in the private sector for what they can reveal about consumer behaviour.

Thaler has an investment company, Fuller and Thaler’s Asset Management Inc. whose mission statement says: “Investors make mental mistakes. Fuller and Thaler’s objective is to exploit them”.

Let us hope that Sri Lankan businesses do not use the findings of Thaler, Sunstein, Ariely, and Kahneman et al to manipulate customers and seek unethical advantage. Providers must respond with justice to the rational concerns of their customers.

The UK’s chief consumer watchdog, the Office of Fair Trading, launched a behavioural economics unit and the National Audit Office has called for more government agencies to apply the discipline’s findings. Watch this space.

Now the markets themselves have gone completely haywire and have lost any pretence of rationality or conforming to text-book theories. Those who demanded deregulation are running to governments for bail-outs. It will be interesting to see how the behavioural economists will help Obama through this mess.