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Economics for mugs

19 June 2015 By Edward Chancellor

The economics profession has been in the doldrums of late – its leading practitioners failed to anticipate the financial tsunami that crashed over the global economy a few years back. Economists were out of touch – lost in their complex mathematical models that were built on highly unrealistic underlying assumptions. Repeated bouts of market turbulence, however, have been a boon to one relatively new branch of the discipline.

Behavioural economics, in the words of Richard Thaler, one of its founding members, is “economics done with strong injections of good psychology”. Conventional economics is peopled with agents who act consistently to maximise gains and minimise losses. The humans who inhabit the real world are rather different specimens: their preferences are inconsistent and unstable, their reasoning faulty and their actions motivated by matters other than utility maximization. Damn it all – they have feelings!

The behaviouralists have uncovered a number of “anomalies” which don’t chime with the assumptions of mainstream economics. Our attitudes to money are quirky – one dollar turns out not be quite like another. We dislike losses more than we enjoy gains; we save more out of windfalls than from ordinary income, and yet are reckless when it comes to spending lottery-like gains; we are liable to reject a guaranteed profit if we feel the transaction is unfair; and we discount future income at an excessively high rate. A bird in the hand really is worth two in the bush.

To cap it all, the accuracy of our forecasts is marred by a tendency to jump to conclusions based on the limited amount of evidence at hand. Humans are overconfident – most people believe their driving skills are above average.

“Misbehaving,” the catchy title of Thaler’s latest book, has been tested in the economists’ labs. A famous experiment involved handing out mugs to some of the students in Thaler’s class. The students who received the mugs turned out to value them more highly than those who didn’t. This finding has been called the “endowment effect”. Other well-known misbehaviours include “myopic loss aversion”, “narrow framing”, “anchoring”, “quasi-hyperbolic discounting”, and “mental accounting”.

Behavioural economics is now taught at universities and business schools around the world. Thinking about finance has been particularly affected by its findings. Before Thaler and his ilk arrived on the scene, academic economists argued that financial markets were efficient. An extreme version of this view held that stock market prices were always correct. Speculative bubbles were the stuff of fantasy – like unicorns.

The dot-com bubble showed the exponents of market efficiency to be wrongheaded. Robert Shiller, a leading behavioural economist at Yale, published his book “Irrational Exuberance” in early 2000 just as the Nasdaq technology index was peaking. A few years later, Shiller was back again warning that U.S. homeowners held unrealistic expectations of future house-price rises. Ever since Shiller’s bearish predictions were vindicated, market practitioners have paid more attention to behavioural finance. Even in academia, where ideas are notoriously slow to change, almost no one believes anymore in the extreme version of the efficient market theory.

Behavioural economics has become established both in academia and in the public mind in a relatively short period of time. Shiller and his fellow behaviouralist Daniel Kahneman have been awarded Nobel prizes. Part of the appeal comes from substituting lively anecdotes for dry theory. In this book, Thaler draws on TV game shows and NFL player recruitment to illustrate his points. Such anecdotes make for entertaining books, including “Nudge,” a bestseller co-authored by Thaler.

In the current volume, Thaler describes his attempts to establish behavioural economics within the ivory tower: persuading academic journals to publish “heretical” findings, organizing workshops and summer schools, and participating in debates. By his own account, Thaler relished playing the role of a pit bull terrier when taking on the economics establishment at his own employer, the University of Chicago, a citadel of market fundamentalism.

Behavioural economics has been embraced by policymakers. Thaler helped create a “Behavioural Insights Team” for the UK government and has influenced pension legislation on both sides of the Atlantic – it turns out that the level of pension contributions is influenced by how the default option is presented to workers. When people are behaving irrationally, Thaler recommends what he calls “prompted choice”, a fancy name for a nudge.

Thaler concludes his book asking where behavioural economics might go in the years ahead. The best guess is that it goes nowhere. This is because behavioural economics amounts to nothing more than a collection of “cognitive quirks” – a derogatory but apt term struck by the legal scholar Richard Posner.

Behavioural finance lacks a coherent theory. Nor are its findings particularly original – marketing people have long known how to exploit the inconsistencies and petty irrationalism of consumers. Investors have been aware of the “madness of crowds” from the time of the Dutch tulip mania in the early 17th century.

As Thaler admits, behaviouralists have made no contributions to the field of macroeconomics. Nor were they any better than their rationalist colleagues at anticipating the financial crisis – despite Shiller’s observations that U.S. house prices had diverged from their long-term trend. Behavioural economics has no insights into the errors of monetary policy. Nor can we ascribe the global financial crisis to human irrationality alone. Much of the “misbehaviour” on Wall Street was perfectly rational from the bankers’ perspective: it earned them large bonuses.

Thaler cites Thomas Kuhn’s well-known work on scientific revolutions. He argues that dominant paradigms are toppled when researchers find so many faults (anomalies) that existing theory is fatally weakened. Behavioural economics, Thaler seems to believe, can bring about such a revolution in economics.

Yet Kuhn also observed that flawed paradigms can endure for a while with minor patches. Behavioural economics has made useful contributions to the field of decision-making. But lacking theoretical heft, it can be nothing more than a colourful patch on the sickly corpus of modern economics.

 

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