Problems with Behavioral Economics

It’s not just liberals who are enthralled by behavioral economics. Since it appears to be science and since its inventors have received multiple honors, many conservatives have happily touted the new discipline.

What could be wrong with using public policy to induce, to nudge, even to force people into making better decisions about their finances?

Critics of behavioral economics have suggested that its proponents, especially those who want to apply it to policy, suffer from a puppeteer complex.

Those who possess great minds see their inferiors as marionettes are awaiting the arrival of a better puppeteer. The proponents of behavioral economics do not respect what happens when free individuals make free decisions in free markets. They believe that markets are fundamentally inefficient because they are prone to speculative bubbles provoked by irrational actors. Some question whether there really is such a thing as free choice.

Surely, there is value in behavioral economics, but it still seems to be the latest attempt to allow an oligarchy of great minds, what Plato called a guardian class, to control the economy.

Last month, economist Allison Schrager wrote an excellent column about the limitations of behavioral economics.

As she wrote:

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.

What, after all, makes anyone think that regulators will always act rationally? Doesn’t behavioral economics assume that government officials, unburdened by the profit motive, will always do what is in the best interest of the collective? Isn't there a name for this?

And then we need ask who decides what constitutes irrational behavior. What is the difference between irrational behavior and a mistake? Is there a difference? Surely, different people assess risk differently. If a high risk investment works out, who is to say that it is irrational?

Clearly, some people do act contrary to their best interest. But if someone decides that thrills are more important than economizing, who is to say that he has made an irrational decision?

And, Schrager continues, what gives anyone the right to change someone else’s behavior:

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. 

Of course, this is the crux of the debate.

We know that people who do not save for retirement may become utterly destitute. So, we have a Social Security program that forces them to save for retirement.

No one objects to the program.

And, if someone smokes or drinks to excess we know that he may need more health care, paid for by the state. So, we institute sin taxes to discourage such behaviors and, in principle, to pay for the medical cost of such behaviors.

No one has a problem with that, either.

Strictly speaking, neither instance involves nudging people toward better behavior. It imposes a discipline. Neither involves rigging markets to produce desired outcomes.

We did not need behavioral economics to institute Social Security. Behavioral economics has been more ambitious, in one sense, and more restrained in another. Many of its policy proposals have seemed to be innocuous.

Schrager reports:

But the limits of these policies are apparent in a new OECD 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?

Here, she could have mentioned Obamacare. After all, the policymakers who dreamed it up believed that no one would mind being lied to about keeping their plans or their doctors because they would easily accept that the new plans were cheaper and better.

Under the aegis of behavioral economics President Obama and the Democratic Party decided that people would not care about being deprived of their freedom. As of today, it appears that they do.

Do people really not care about being deprived of the right to make a mistake? Again, who decides what is or is not a mistake?

Economists frame the question in terms of the relative efficiency or inefficiency of markets. Some believe that markets are inefficient and need to be strictly regulated. They know that human beings are capable of speculating and making bad investments. They believe that these excesses must be prevented by the intervention of government authorities.

Defenders of free markets believe that markets produce rational results, but are capable of becoming irrational. Markets tend to correct speculative bubbles. It might not be pretty but it does happen.

Worse yet, Schrager continues, what makes anyone think that regulators, who are human beings too, know what is best for everyone and have the capacity to engineer it.

In her words:

According to [Robert] 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, …  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?

As I understand it, the Federal Reserve policy of quantitative easing is one of the most grandiose efforts to save the financial system by controlling the bond market. 

One day we will know whether these activities have simply put off the inevitable, even made it worse, or whether they have saved the world.

Will the bond market find an equilibrium that promotes economic growth and fiscal stability or will the forces of correction rear their ugly head once more.

Free marketeers like Jim Grant believe that a market denied will take revenge on those arrogant souls who believed that they knew better.

Today, we read this story in Business Week:

When the Federal Reserve raises interest rates, it will probably cause a financial-market convulsion similar to the “tantrum” that occurred last year after the Fed said it was considering trimming its bond purchase program, economists said in a warning to policy makers.

“Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear,” said the economists including Michael Feroli, the chief U.S. economist for JPMorgan Chase & Co. in New York, and a former Fed economist. “Risks of instability have not been eliminated.”

The warning coincides with a Fed debate on whether to give more weight to concerns over financial stability when changing so-called forward guidance or monthly bond buying known as quantitative easing. Feroli and his coauthors presented the paper to a gathering including Fed Governor Jeremy Stein and at least six other Fed policy makers at the U.S. Monetary Policy Forum in New York.

“Our analysis does suggest that the unconventional monetary policies, including QE and forward guidance, create hazards by encouraging certain types of risk-taking that are likely to reverse at some point,” said Feroli and his co-authors Anil Kashyap of the University of Chicago, Kermit Schoenholtz of New York University’s Stern School of Business and Hyun Song Shin of Princeton University.

It's not so easy to ride a tiger.