Richard Thaler has won the Nobel Prize for initiating the behavioral moment in economics.
My view of the Nobel Prize in economics is much like Time magazine’s view of its “Person of the Year.” It is awarded to the economist who “for better or for worse… has done the most to influence” the course of economic thinking – at least in certain respects. It also, like Time magazine, operates under the constraint that an award must be given every year.
Winning the Nobel Prize is also a little like dying. The Romans quite rightly caution us against speaking ill of the dead. We, the living, do not want our lives to be summarily condemned or dismissed by others when we are gone. We want understanding and a bit of generosity toward our foibles as well as recognition of where we went right. So too in the sphere of evaluating Nobel Prize winners and their contributions. And yet we must avoid the bias of assuming that all intellectual developments that capture the imagination of the latest bright young stars are for the best.
Nevertheless, the emphasis on the limits of the standard rational paradigm has been a very refreshing and useful thing.
To begin with the better. Neoclassical economics has for a long time made very strict and narrow assumptions about what it means to be “rational.” In particular, the neoclassical agent is always consistent. He (she, it) has a preference over all things that are feasible to do. He never exhibits a bias for current consumption. And so on. But in his defense: He is not (as some critics of economics contend) a mere selfish, money maximizer. He is as selfish or unselfish as the rest of us. As narrow as it is, “rationality” does not mean selfishness. But it does mean that he is quite unlike any person we know. He never worries about the marginal disutility of worrying about marginal utility.
And now for the worse. But what is wrong about this is not what Thaler and behavioral economists think is wrong. Neoclassical man was never intended to be an image of a real person. He was, and is, a puppet – a theoretical construct designed to generate predictions about market or aggregate behavior. Much like the unrealistic assumptions in natural science he functions as an analytical device. The market is not a mere reflection of individual decision making abilities. It is a filter in which competition and other institutional constraints alter outcomes. Often the market produces outcomes that are different from the intentions and capacities of the individual agents. I would argue mostly for the better; but sometimes not. But almost always different.
Refreshing the Discipline
Nevertheless, the emphasis on the limits of the standard rational paradigm, as pioneered by Thaler, has been a very refreshing and useful thing. And yet behavioral economics remains wedded to this narrow conception of rationality as a normative and prescriptive standard of evaluation. It drives the critique of many market outcomes and is the basis of policy prescriptions. It is precisely because people are not narrowly rational that their behavior must be fixed. Their behavior must be taxed, regulated or nudged in the direction of the behavior of the perfectly rational neoclassical man. For example, it is alleged that people are obese because they fail to take “full account” of the negative effects of their unhealthful eating habits. What is full account? They must reckon or discount these effects at the rational rate of discount – the long-run rate, the rate one would use if one were super-rational and calm in making a diet plan to be implemented in, say, six months or a year. But how the agent looks at things now, at the moment of deciding what to eat, is wrong. It is impetuous. It is “present biased.” The individual needs help. And, in practice, it is the government’s help.
Aside from the policy implications, there is an incredible irony here. Standard economics is mocked for its rationality assumptions and yet those assumptions are held up as an ideal for real human beings. It is as if there is a neoclassical man deep in each of us struggling to get out but he is continually bombarded by behavioral shocks. Behavioral policy is about nothing less than becoming the real you! All this despite your resistance.
A large literature in psychology casts doubt on many of the bias truisms.
Behavioral economics has a foundation in the psychological work of Daniel Kahneman, another Nobel Prize recipient in economics. Many of his findings, outlined in his book Thinking, Fast and Slow, have taken on the status of truisms. People are plagued with all sorts of cognitive biases that lead them to wrong decisions. The field has produced more than a hundred and fifty such biases (see the Wikipedia page). They have become a grab bag of “tools” to use in a myriad of policy-relevant cases. People save too little; they eat too much; they borrow too much from payday lenders; they get into credit card debt; they don’t enroll in retirement programs; they are too optimistic about their abilities to cope with bad events (the occurrence of which they may be too pessimistic); they smoke too much because they do not “fully” appreciate the dangers of smoking or their personal vulnerability; they cannot appreciate the full personal value of saving energy costs; they are unaware of “shrouded” costs in the financial area because of…well, you name it. All this is a veritable industry. More jobs, more journal articles, and more policy advisors.
But now the even worse: Most people – and I would add most economists – are unaware that there is a large literature in psychology that casts doubt on many of the bias truisms. The most important of this work has been carried on by Gerd Gigerenzer and the ABC Research Group at the Max Planck Institute in Berlin as well as many other distinguished scholars. It is one thing to construct clever experiments in which people do “odd” (unexpected by the standard paradigm) things. It is another to show that they engage in behavior in the real world that is ecologically inappropriate or that leads to self-defeating behavior. “Odd” behavior should be viewed as an invitation to probe more deeply rather than to condemn. Explanation is hard; evaluation can be easy and cheap.
Even among economists, there is much dissent. Look at the work of Vernon Smith, another Nobel laureate in economics, whose experimental economics has pushed us into a recognition that the errors or imperfections of individual decisionmaking need not result in poor outcomes — if the institutional structure is good. Smith has carried on the tradition of the Scottish Enlightenment which emphasized time and again the compatibility of imperfect men and outcomes that embody far more “intelligence” than any of them have as individuals.
If the awakened economics accepts the truisms and biases of behavioral economics then that would be bad for economics.
Currently, I am thinking and reading about “present bias” – the excessive discounting of the future that Thaler, especially, told us characterizes decisionmaking about current action. It might be quite informative to learn that the evidence for present bias in monetary decisions is very weak. Many new and highly sophisticated empirical studies fail to find any such bias. Or, if they do, it is quite small. The truism may not be true, after all.
There is so much more to say. Glen Whitman and I have said a lot as early as 2009 in our articles in the Arizona Law Review and the Brigham Young University Law Review and elsewhere. We will have even more to say in our forthcoming book Puppets and Puppet Masters.
The philosopher Karl Popper used to say that we learn much from our mistakes, even more than from our successes. The same is true about a profession. The stir created by behavioral economics has been good for economics and Richard Thaler has been an important part of that. It has awakened economics from a self-satisfied slumber. But if the awakened economics accepts the truisms and biases of behavioral economics then that would be bad for economics. It would be yet another self-satisfied slumber. The behavioral moment is an opportunity to re-evaluate standard economics but also to correct the errors and direction of behavioral economics, and then move on.
Reprinted from Think Markets.