Past Rationality: The 2017 Nobel Award for Economics

Paul Krugman, the 2008 winner, tweeted ‘Yes! Behavorial econ is the best thing to happen to the field in generations, and [Richard] Thaler showed the way.'

Good science is essentially a subversive activity. Most scientists work within the existing paradigm – the framework of the basic assumptions, ways of thinking, and methodology commonly accepted by the discipline. The better ones keep an eye out for anomalies which require some adaptation of the paradigm. The great ones identify anomalies which cannot be so readily accommodated and transform the paradigm to account for them. However, it can be a long path to beat the existing conservative scientific establishment.

This is true in economics-as-science (but not in economics-as-ideology), as the 2017 Nobel Memorial Prize in Economic Sciences to Richard Thaler reminds us. In the late 1980s Thaler wrote columns in the Journal of Economic Perspectives, each identifying an ‘anomaly’ in human behaviour. (They are published in The Winner’s Curse.) To be precise, the anomaly is not in human behaviour but in the economic paradigm which was underpinned by the notion of Homo economicus – rational economic man. (Yes, women were to be embraced by men.)

I was enthusiastic about the book because it seemed to characterise human behaviour as more like the way that people I knew behaved (including me). Thaler says he once explained the difference between his account of human behaviour and Robert Barro’s (an eminent economic rationalist), by saying that Barro assumes that people are as smart as he is, while Thaler portrays them as being as dumb as he is. Barro agreed.

Economics is a very old science, older than psychology-as-science, so it is perhaps inevitable that its initial behavioural assumptions would be primitive. But the paradigm got stuck on them. Partly they were simple (and greatly simplified the mathematics). But economics-as-ideology was attracted because they seemed to support the minimalist state; since people made optimal decisions, there was no need for state involvement, it would only make things worse. Economic scientists knew there was a problem and a Nobel Prize went to Herbert Simon in 1978 for trying to modify the narrow rationality assumption with the notions of satisficing and bounded rationality.

Because it is subversive, a science progresses. Psychologist Daniel Kahneman was also awarded an economics Nobel in 2002 (you may have read his book Thinking, Fast and Slow). The economist who particularly drew upon Kahneman was Thaler, joining the illustrious two Nobel laureates this year.

You can read more about Thaler in his book Misbehaving: the Making of Behavioral Economics, A History of the Development of Behavioral Economics, which he describes as ‘part memoir, part attack on a breed of economist who dominated the academy – particularly, the Chicago School that dominated economic theory at the University of Chicago – for much of the latter part of the 20th century.’ (Thaler is a Chicago professor.) You may have seen him on screen in a cameo performance in The Big Short (about the 2008 global financial crisis) in a scene alongside pop star Selena Gomez. He explained the 'hot hand fallacy,' in which people think whatever's happening now is going to continue to happen into the future.

Supporting behavioural economics has not been an easy path. When I first came across Thaler’s work a quarter of century or so ago, I found little enthusiasm or interest in the New Zealand profession. Some just did not get it, others were unwilling to abandon the habits of a lifetime and, of course, ideologists saw it threatening their policies.

Even though there has been the occasional (and lonely) behavioural economist here, we have got a bit behind the frontier. Admittedly Kiwisaver conforms to some of the Thalerian savings principles, but its designers do not seem to have consciously drawn on them (and much of the criticism of the scheme assumes rational economic man).

It is instructive that we have never promoted a ‘nudge’ approach inside government. By way of background, Kahneman and Thaler recognise that the way a choice is set out can determine the decision. For instance, once Austrians had an opt-out provision for organ donations; Germany had an opt-in. Almost all (99%) Austrians agreed to donate after their death, but only 12% of Germans did

Thaler, with eminent lawyer Cass Sunstein, wrote Nudge: Improving Decisions About Health, Wealth, and Happiness, which discusses how public and private organisations can help people make better choices in their daily lives. They said, ‘people often make poor choices – and look back at them with bafflement! 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.’ They suggest that the public sector should design its choice systems to ‘nudge’ people to make decisions which reduce these biases and blunders.

By now many right-libertarians will be crying ‘paternalism’; although they seem less concerned that businesses use the principles of the architecture of choice to pursue profit. Thaler and Sunstein describe their approach as ‘libertarian paternalism’ (also ‘soft paternalism’). ‘The libertarian aspect of our strategies lies in the straightforward insistence that, in general, people should be free to do what they like – and to opt out of undesirable arrangements if they want to do so.’ The paternalistic portion of the notion ‘lies in the claim that it is legitimate for choice architects to try to influence people's behaviour in order to make their lives longer, healthier, and better.’ I am more pragmatic; when business starts tossing a coin to set choice as an opt-in or opt-out then so should government.

A number of governments – including conservative ones – have set up ‘nudge’ units to develop this architecture, but not New Zealand. (Instructively the social investment literature which is our current fashionable innovation goes back to developments in the 1950s; the pioneers were dead by the time it was their turn for a Nobel.)

While the nudge units are a useful policy response, behavioural economics is much more subversive (hence Krugman’s endorsement of its importance). Who can tell where it will lead economics? Recall that Rutherford thought his research on the composition of the atom had no practical use; only a few years later he recognised the possibility of nuclear energy. (That is real subversion for you.) If I had to make a guess behavioural economics probably means a less mathematical economics; one which draws on a wider range of the other social sciences but in a less imperial, more empirical way and one which better represents human behaviour.

Many years ago I summarise the critique of Thaler’s research as economists trying to impose on the public their narrow self-conception of the human condition. Their behaviour is not of ordinary men and women, who may be economically irrational but do wonderfully human things like laugh and cry, show curiosity and awe, love, care, and create beauty.