Behavioural Economics: Should Policymakers Care?

Behavioural Economics is one of the main drivers of modern economics but we have not spoken about how ideas from this field are relevant to current Irish economic conditions. This is not a blog just for specialists so I am going to try to give some jargon-free sentences on what behavioural economics is and why policy-makers should care. This is purely my own view having researched the area since 2001 and having lectured courses in TCD and UCD on the topic and they do not reflect any attempt at capturing the consensus opinion in this field. I feel very strongly of the view that the absence of an understanding of both psychology and of policy evaluation has damaged Irish policy and that a continued cynicism about the capacities of the Irish public sector to deliver innovative policy is leading many to stop trying to think of innovation. Behavioural Economics combined with rigorous policy design is a partial corrective to these tendencies.

Basically, behavioural economics focuses on the application of psychology to economic behaviour. Increasingly, it is focused on why people make decisions in key domains relevant to economic policy. A trend has been the development of the view that policies need to be designed rigorously with respect both to potential evaluation and with respect to actual psychological principles and that such policies should stand or fall on the basis of whether they work. A recent Economist article put this at the heart of the next ten years of economics arguing that the union of behavioural economics and policy evaluation represents the most dynamic tendency in economics. Just because the Economist says it, doesnt make it so, but we should give this work credence in thinking about a potential Irish recovery.
The most developed literature that can be applied in Ireland is the one on pensions. John McHale wrote a great piece a few years ago summarising some of the literature up to then on behavioural economics and pensions and its relevance to the Irish situation. It did not seem to have much of an influence on the debate, which is a shame. In general, financial decision making is the first area that really should be looked at if policy makers want to take behavioural economics seriously. Tax codes, legal codes, social welfare entitlements and so on are need to be gone through not just from the point of view of accounting waste. We need to look in depth at what financial incentives exist for people and how people interpret these financial incentives and whether people are disincentivised by the framing of these processes. Several experiments in the US are starting to show that simple questions of how instruments are framed, the cognitive complexity of application forms, the nature of the default setting can all have dramatic effects on behaviour. As pointed out by Akerlof and Shiller, the interaction of the psychology of financial decisions with the regulatory structure generates a lot of the negative effects seen on financial markets.
McHale Article

Secondly, behavioural economics is also focused on the outcomes of people’s decisions and, in general, is not wedded to the view that consumption is a good measure of people’s well-being. Focusing on well-being directly is increasingly a concern in behavioural economics.  In particular, looking directly about how factors such as health, unemployment, aging and so on determine well-being is increasingly a guide to developing policy. The UK have taken seriously the idea that things like home foreclosure and unemployment are not just economic events but are also psychologically distressing and have been provided psychological therapy on a more wide ranging basis than before, based on recommendations from this literature. Several other policy ideas derive from looking closely at well-being and these should not be dismissed lightly and certainly not without some debate.
Thirdly, behavioural economics is increasingly focusing on actual policy experiments in real world contexts. My own opinion is that this is the prime way in which economics can positively impact recovery in Ireland. In particular, well-designed micro-policy experiments in areas such as health, financial decisions, based on sound principles about how people actually behave is the main thing we can take from this new literature. This does not necessarily mean more government intervention (it may mean less). However, it does mean far more active discussion of specific micro-level policies in areas such as education, training, innovation and so on. A focus purely on expenditure to the absence of actual outcomes and process is characterising a lot of the current debate and this is damaging.
Some recent popular works written by leaders in the field that people might be interested in if they want to understand the potential relevance of behavioural economics to current policy are linked below.

14 thoughts on “Behavioural Economics: Should Policymakers Care?”

  1. Just what do …. you….. want …. them …. to do?
    You are talking of motivation, yes? Policies. Therefore politics. Yet content is difficult to find.
    Freedom is the best motivator. Free to find their niche. Free to bind themselves with mortgage, loans and economic input and out put. And then they lose their input, their job for most of them. So they shut down. And economic theory suggests that most can be reactivated. But not if they suicide. Or migrate. Or retire. But many of the motivator folk view them as a problem anyway and the fewer of them “the more jobs for the rest”?
    Not quite as bad as a world war but what is it you propose? Or do you mean what is already there? We are not organizable along those lines. Yet. Division and greed are the currently preferred behaviour patterns. What do you propose?

  2. Should there be religious movements, bands who believe the world is warming say? And there will be others that believe the opposite? They can equip themselves with a model such as off the grid or miser or some such? There need be no physical clash but this may also mean fragmentation of society as we are very fragile now. Timing seems key to the success of your proposal? There are adjustment issues if you are successful. Societal institutions are based on trade and progress. Will any idealogy that does not embrace these be discouraged?
    I am merely showing a point of view, but it seems like something tptb would suppress rather than encourage. Solari seems to be an example of this? Tinkers were a primitive example, excellent at the time, but anachronistic now as humans tend to hold onto their re inforcement for far longer than they should. Give an example?

  3. The main problem with the “new” economics (think behavioural, “happiness” economics) is that they assume that the policymaker knows more about what will bring about general well being than the individual himself.

    The Thaler and Sunnstein text in particular is just a rationale for governments to persue *their* favoured vision of general good.

  4. @Liam, I recently finished the excellent Animal Spirits by Akerlof and Shiller, and it certainly is a new way of looking at economics.
    I’m in no position to start re-inventing the economic wheel here, but they do make a compelling argument. To me (currently a PPE student) there seems to be a fundamental disjoint between economic theory and the actors upon which it is based, on the micro-economic level. For example, with my economist hat on, I can say that the ESB should have no domestic customers left in Ireland now that a new supplier has arrived on the market offering the exact same product at a 10-15% discount. Yet, the facts of the matter seem to dispel the theory, as consumers seem slow to change.
    Why is this? Maybe there is an answer in behavioural economics. Or maybe it is just consumer apathy.

  5. Liam,

    Thank you making this post. It helps to shift the focus from the macroeconomic fetishism that tends to dominate most posts on this site. (In passing, I’m not sure what Pat Donnelly is on, but he seems to have gotten to somewhere else before us and it seems to suggest admirable and liberal moderation of posts.)

    My instinct is to agree with Matt that this approach reinforces the ability of dominant businesses or centralised government to manipulate the over-managed consumer or citizen described, many years ago, in Herbert Marcuse’s “One Dimensional Man”.

    To make your post intelligible to the uninitiated you have made reference to recent articles in The Economist. To illustrate my key points an article in the current Economist is apposite:

    http://www.economist.com/business/displaystory.cfm?story_id=13415207

    This describes the distaste consumers are developing in response to the tactics of over-bearing goods and service providers which is likely to extend beyond the current economic and financial crisis. Consumers and citizens have been atomised, disenfranschised and disempowered by government and the major providers of goods and services – for example, providers of banking, insurance or pensions and of FMCGs, white goods or durable goods.

    Consumers have little or no access to “collective wisdom” – the wisdom of crowds – or genuinely objective information that is not crafted, filtered, focused or manipulated by the providers of goods and services.

    The consumer may be king, but, if the empire fails to deliver, he has no army to engage the forces ranged against him. He has to expend time and effort and incur significant expense to recruit the mercenaries to fight his cause. And most individual consumers have neither the time not the resources to engage in this battle. The dominant providers of goods and services to final consumers have progressively broken down, undermined or neutered any form of personal engagement, of local bond, of service provision by competing collective action or of counter-vailing market information or market power. The media are held in thrall by product and service freebies and advertising revenues. The internet reveals a cacophony of voices whose impact is generally too diffuse in practice, but it has potential to generate effective collective action.

    Conventional neoclassical microeconomics, despite the continual accretion of insights over the years, informs much of competition policy enforcement and the regulation of sectoral monopolies, but it is proving seriously deficient.

    The US gas and gas pipeline markets which are probably among the most efficient in the world, unlike gas markets in other OECD countries, do not lend themselves to analysis solely in terms of conventional microeconomics. They require analysis in terms of the transaction economics pioneered by Ronald Coase (Nobel Laureate in 1991), the institutional economics developed by Douglass North (Nobel Laureate in 1993) and the theory of collective action pioneered by John R Commons and further developed by Mancur Olson.

    Collective action is more deeply embedded, more in tune with atavistic instincts for security and solidarity and more prevalent globally than a cursory assessment would suggest. Legal “class actions” are an excellent example, but mutualised savings and loans entities, municipal provision of utility services and the range of NGO activities are important examples that are evident globally.

    The challenge is to engage and energise the “small battalions”. There is a literature that suggests that people may be economically illiterate individually and make dumb decisions when confronted by overbearing service providers and make dumb decisions collectively when egged on by rabble-rousers playing on tribal and atavistic prejudices, but, in general, when treated as sentient beings, they tend to have a well-developed understanding of where their best interests lie.

    There is a tendency to treat the current economic and financial crisis as a technical problem to be resolved and then we will then be able to return to “business as usual”. But we are confronting serious and sustained market failure There is growing public anger at the bail-outs of the financial system which generated this mess and an increasing perception that greed and incompetence are being rewarded. Free markets are being seen as a major part of the problem – rather than the mechanisms that generate efficiency, innovation, productivity and prosperity. Space is opening up for demagogues, populists, xenophobes and rabble-rousers. Every ethnic, religious or national grouping of any size has the potential to produce a Hitler.

    Estimating the structural/cyclical deficit split is the modern equivalent of fiddling while Rome burns. If we move beyond the straitjacket of conventional macro and microeconomics we have the tools to address these problems.

  6. Liam, I find this post, and most of the subsequent comments on it, very interesting. However, reading through the reference articles it struck me that behavioural economic theories, such as they are, are based on studies about what people will do in relatively normal circumstances, not in a crisis situation.

    What we do know is that in a major crisis the herd instinct kicks in – the wildebeest factor again, where one animal smells a lion in the long grass and soon they’re all stampeding like mad without individually knowing what direction they’re heading in or why. In major crisis situations people head for those insitutions which they associate with safety and authority e.g. hospitals, schools, churches, police stations etc. and thereby risk clogging up the very services that are needed to help them. As individuals, we also tend to revert to best known forms of behaviour that have seen us through tight spots in the past e.g. smokers who’ve given up for twenty years go back on the fags and so on.

    What’s happening right now represents a genuine crisis in our society and I’m not sure that behavioural economics is best positioned to indicate any solutions or policy options that might prove useful. A study of economic history, or anthropology, might be a better bet.

  7. @Matt: “The Thaler and Sunnstein text in particular is just a rationale for governments to persue *their* favoured vision of general good.”

    But if they get it wrong, the rascals can be thrown out.

    Whereas it seems to be very difficult to get rid of CEOs.

    bjg

  8. Latest daft.ie report is out today – commentary is by Liam, who applies some of his thinking on behaviour and economics to the latest data from the property market. Ties in some of Gerard O’Neill’s shift to renting story also:
    http://www.daft.ie/report

    Further commentary here, http://ronanlyons.wordpress.com/2009/04/06/irish-house-prices-fall-4-since-the-start-of-2009-latest-daftie-report/, and on thepropertypin here, http://www.thepropertypin.com/viewtopic.php?f=4&t=20483.

  9. The relationship between behavioural economics and well-being needs to be thought of like overlapping circles. There is certainly a component of behavioural economics that deals with well-being but there are also distinct components of each literature. My sense is that many economists would have problems with all the well-being literature, but would accept some of the new behavioural findings, particularly in areas like time discounting.

    Lorkan mentions switching behaviour and this is definitely one of the clear areas where more detailed analysis of behaviour is required to supplement economic models. Things like procrastination, loss aversion and so on are clearly operant in many markets and low rates of switching are generally thought of as placing a constraint on the effect of competition policy and regulation. Increasingly, financial regulators are starting to track things like financial literacy, how people understand interest rates and so on, to take into account the fact that people don’t process information perfectly. There are a lot of factors like this that might lead to puzzling behaviour, though I know nought about the particular market you are describing.

    The final point I would make is that the type of behavioural work I think has most relevance in Ireland right now is work directed at designing tax, labour market and financial policies. This does not mean writing epic treatises about the nature of man. Rather, it means being more flexible in thinking about the type of variables that might work in the context of labour market and innovation programmes and above all trying some of these things out. We have several programmes run by FAS, as well as County Enterprise Boards, University Innovation Programmes and so on. Although they take place in a macro-context, these are micro-programmes and their success depends on the interaction between the incentives offered and the way people interact with them. Its at this level that a form of behavioural economics can actually have an impact on the economy. Economists would call it “programme design” influenced by behavioural economics.

  10. Liam, great post.

    (And thanks for the generous reference; unlike youself, I am just a consumer and not a producer of behavioural economics.)

    I completely agree that economics with a richer behavioural foundations would lead to better policy design in many areas. This is one of the most exciting research areas in economics in my view.

    A sampling of policy issues thrown up by the crisis that strike me as particularly interesting:

    Unemployment. Conventional work on unemployment has stressed how the interaction betrween certain labour market institutions/policies and shocks can lead to long-lasting impacts on the unemployment rate (see, e.g., the work of Olivier Blanchard and Justin Wolfers). These findings have implications for the setting of replacement rates, the design of active labour market policies, etc. On the other hand, work in the behavioural mode has drawn attention to the dramatic effect that the experience of unemployment can have on well-being. The challenge is to design policies that push and pull people back to employment while paying close attention to material/pyschological deprivations associated with unemployment.

    Money illusion. Ackerlof and Shiller draw attention to the pervasiveness of money illusion. This is very relevant at a time where nominal wage and social welfare benefit cuts are needed given price deflation. Nominal rigidities are likely to deepen the recession and the fiscal crisis. Is it possible to design politically and socially acceptable indexation arrangements to bring about the needed downward nominal adjustments?

    Pensions. There is growing — though certainly not universal — acceptance that many of us under-provide for their retirements. Work such as that by Thaler and Sunstein has also shown how small changes to the “choice architecture” can move savings behaviour in a welfare improving direction. I have no doubt that retirement savings policies could be designed that would both raise retirement savings and be less costly to the exchequer. This is the type of policy innovation I explored in the piece that Liam references. My focus there was primarily on funded pension arrangements. The recent crisis has made me re-evaluate the relative attractiveness of funded versus unfunded arrangements given: (1) the urgent need to support consumption in the short term; (2) the fiscal crisis; and (3) the reassessment of the riskiness of financial investments. There is an urgent need for policy innovation to design an effective multi-pillared pension system that balances innovative funded and unfunded elements.

  11. Thanks John – I am actively thinking about how to get such ideas more widely circulating. Getting some good experiments (do not necessarily need to be full blown randomised ones but at least with a defined structure) going would be a good statement to the world that we are open for business in terms of reforming policy. A widespread review process played out in public on the types of experiments with the highest probability of success in the most pivotal areas is a key step.

    Im just not sure how this plays out with the broader macro analysis. This of course sets the context for what can be done in terms of money, but at present the macro situation is being used to encourage paralysis on the micro-side with continuous fear and defensiveness being the dominant themes in places where micro-policy is shaped rather than the energy of people with enthusiasm and ideas.

    The ability to do innovative policy experiments in the context of a very hierarchical public service and a centralised decision making environment is also open to debate. In areas like obesity for example, it scares me to think how quickly businesses can roll out experiments designed to get kids to eat junk food compared to how long it would take to do something to counter this in the public sector. Im not necessarily criticizing the latter for this but its a fact of life that things take longer to do when you have lots of layers to go through. For many people, the prospect of setting up a policy experiment compared to a business experiment sounds like a lot of work.

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