Don’t believe the hype about behavioral economics..Really?

Allison Schrager a NY based economist says beh eco is mainly hype.

She says beh eco has not delivered the expected results:

I have a confession to make: I think behavioral economics is over-rated. Recently, Nobelist Robert Shiller called on economists to incorporate more psychology into their work. While there are certainly things economists can learn from psychology and other disciplines to enrich their understanding of the economy, this approach is not a revolution in economics. Often models that incorporate richer aspects of human behavior are the same models economists always use—they simply rationalize seemingly irrational behavior. Even if we can understand why people don’t always act rationally, it’s not clear if that can lead to better economic policy and regulation.

Mixing behavioral economics and policy raises two questions: should we change behavior and if so, can we? Sometimes people make bad choices—they under-save, take on too much debt or risk. These behaviors appear irrational and lead to bad outcomes, which would seem to demand more regulation. But if these choices reflect individuals’ preferences and values can we justify changing their behavior? Part of a free-society is letting people make bad choices, as long as his or her irrational economic behavior doesn’t pose costs to others. For example: Someone who under-saves may wind up dependent on taxpayers for financial support. High household debt has been associated with a weaker economy.

Or people may make choices they’ll regret later because they are impulsive and don’t value the future as much as they should. They may not anticipate how bad poverty in retirement will be or how hard it is to escape the vicious cycle of a high debt lifestyle. That might mean policy makers, who presumably are more rational and value the future, have the ability to save people from themselves.

 Hmmm.. This is the broad purpose of beh eco.

The author points to this exciting OECD report which summarises how some countries are using beh eco. The author is disappointed about the findings (though the report is more sanguine):

It’s been argued that irrational economic behavior merits regulation to encourage or force choices that will benefit both the individual and the economy as a whole. But the limits of these policies are apparent in a newOECD report on the application of behavioral economics to policy. The report gives examples of regulations adopted by different OECD countries that draw on insights from behavioral economics. Thus it’s disappointing that, with all economists have learned studying behavioral economics the last ten years,   the big changes in regulation seem limited to more transparent fee disclosure, a ban on automatically selling people more goods than they explicitly ask for, and standard disclosures fees and energy use. These are certainly good policies. But is this a result of behavioral economics (helping consumers over-come behavioral bias that leads to sub-optimal choices) or is it simply requiring banks and merchants to be more honest?

Even if beh eco has helped figure these issues and make people more honest, it is not a mean achievement. As per rational school, the buyers should have figured the cheating. But this was not happening. After all beh eco is not really proposing some grand idea. Just simple ideas..

She asks whether beh eco can fix the financial system?

Poor risk management and short-term thinking on Wall Street nearly took down the entire financial system. Can what we know about behavioral finance regulate Wall Street? According to Shiller, markets are inefficient and misprice assets because of behavioral biases (over-confidence, under-reaction to news, home bias). This leads to speculative bubbles. But it’s not clear what financial regulation can do to curb this behavior. According Gene Fama, Shiller’s co-laureate who believes markets are rational, (Disclosure: I used to work at Dimensional Fund Advisors where Fama is a consultant and shareholder) it’s not possible to systematically separate “irrational” behavior (that distorts prices) from healthy speculation, which aids price discovery. If speculators (who have an enormous financial interest) don’t know better, how can we expect regulators to?

One  possible solution is to change banker compensation to better align incentives. The EU recently adopted a cap on the size of bonuses paid to bankers; the UK is considering a similar rule. The hope is that smaller bonuses will make bankers more thoughtful when it comes to risk and the long-term interests of the bank. But it’s not necessarily true that bonuses made bankers too focused on short-term profits and encouraged excessive risk-taking.  A large part of pre-crisis banker compensation was company stock. Firm ownership gave them an incentive to care about the long-term health of the banks, but they still made mistakes. The best we can do is to force banks to internalize the cost of risk they take on, by ending too big to fail. But so far, there are not many credible policies to achieve that.

She says the biggest success of beh eco is in savings products. And says initial evidence from some other experiments is not encouraging.

Well, I am not sure. It is fine to doubt and expect more successes from beh eco. But it will take a while. The rational school still dominates much of the policy and action related work. Beh eco is at best seen as an experiment and not given much much space. Apart from creating a space for itself it also has to fight this huge inertia of rational school.

And then beh eco is not really a hype but a hope. A hope against the drudgery of assuming rationality and superficial policies….It is actually trying to make economics more believable…

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