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12 October 2017

A timely nudge for economics

Richard Thaler’s Nobel Prize signals a new direction.

by Frank O’Nomics

The economics profession has a very poor track record.  Despite the decades of research that have been spent in analysing the economic cycle, seeking solutions that will ease hardship and promote growth, there has been little progress.  Earlier this year Paul Romer, Chief Economist at the World Bank wrote a paper called “The Trouble with Macroeconomics”, in which he asserted that that branch of social science had been ”going backwards for three decades”.  Macro and microeconomics have each spent a long time becoming almost purely mathematical disciplines, which appears to have left the subjects increasingly detached from the real world.  It is then refreshing to hear that the latest Nobel Prize for Economics has been awarded to a Behavioural Economist, Richard Thaler.

Behavioural Economics, a bridge between economics and psychology, recognises that economic agents are human and that economic theory needs to acknowledge this.  It challenges the standard assumption, that still persists in macroeconomics despite the very human factors behind the 2008 financial crisis, that the economy is made up of “rational actors”.   Central Banks and government treasury departments have continued to apply strict mathematical models to guide policy.  Economists like Richard Thaler propose alternatives where human behaviour is analysed in an attempt to work out solutions to problems such as: how to adjust tax systems when investment is needed, how to stimulate consumer spending when the economy is struggling, and how to discourage borrowing when debt levels once again threaten financial stability.

Thaler has spent many years looking at why people make choices, and demonstrates why a lack of self-confidence, an aversion to risk, an inconsistency in how people value things over time (with a tendency to focus only on the near-term), leads them to behave in a less than rational manner.  If I offer to sell a £20 note for £10 then most people would almost certainly take me up on the offer (only sympathy for my stupidity would stop you), but people repeatedly reject such a proposition when their employer offers to match additional pension contributions.  People focus on their near-term ability to spend rather deferring consumption for their old age.  Similarly, most of us appreciate the risks of unhealthy eating but the temptation of fried food tends to override fears of an early death.  In books such as, Nudge: improving decisions about health, wealth, and happiness Thaler (in this case with Cass Sunstein) looks at how governments might better organise the context in which people make decisions.  The idea is to develop a “Libertarian Paternalism” where people are shown how to make better decisions, without losing freedom of choice.

Behavioural Economics is by no means a new discipline, with other notable proponents, Daniel Kahneman and Vernon L Smith jointly joint Nobel laureates in 2002, and Robert Shiller in 2013.  The policy implications have not been missed by the US and UK governments, with the UK setting up a Behavioural Insights team in 2010 to harness the implications of the research for government policy.  Further, there are plenty of examples of the findings of research being applied to good effect, with Thaler devising a prescriptive life savings programme that generated an increase in the savings rate for the employees of a large company in the US from 3.5% to 13.6%.  Such measures can have a profound impact on people’s retirement prospects and could help significantly reduce the burden on the state.

None of this suggests that Behavioural Economics is some kind of panacea to cure all societal ills.  Indeed, playing on the irrationality of humans can be utilised in a negative way.  If doctors and dentists embraced the concepts of “Nudge” they could push us into a great deal of non-essential and expensive treatment, and payday lenders are amongst the prime exponents of playing upon borrowers short-term proclivities.  Similarly, we cannot say that Keynesian or Monetary economics have nothing to offer.  We can, however, argue that these theories may be much more effective if they incorporate a behavioural element, rather than assuming complete rationality.  For financial regulators, trying to avoid a financial crisis of the order of 2008, the analysis can be effectively used in setting regulations for the financial services industry, helping bankers (and others) to behave for the long-term rather than a short-term bonus.

Studying people rather than adopting abstract models can help generate better government policies. Small incentives can help push people in the right direction – whether that is to save more, pay more tax or donate their organs. Richard Thaler has declared that he will attribute any future personal spending excesses to his $1.1mn Nobel award (he is also no great fan of Donald Trump, having said “I simply cannot lower the bar far enough for him to get over it”).  His response is refreshingly irrational and hopefully the renewed impetus the award has given Behavioural Economics will be a “nudge” in the right direction for governments, and an opportunity for the economics profession to shed some very tired assumptions.

 

 

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