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Calculating the Irrational in EconomicsBy STEPHEN J. DUBNER
hen the Federal Reserve Bank of Boston invited the leading behavioral economists
to a Cape Cod golf resort this month to make their case, it was plainly a
signal moment. "It has the feeling of being summoned by the king," said Colin
F. Camerer, a star behaviorist who teaches at the California Institute of
Technology. "Sort of like: `I understand you're the finest lute player in
the region. Will you come and play for me?' " | Advertisement
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Until the last few years, behavioral economics — which blends psychology,
economics and, increasingly, neuroscience to argue that emotion plays a huge
role in how people make economic decisions — was an extremely tight-knit
group. It had little influence and few practitioners. One economist at the
bank's conference recalled an Alaska kayaking trip that Mr. Camerer took
with another prominent behaviorist a decade ago. "If that kayak had flipped,"
he said, "half the field would have been eradicated." But the field
has grown, as has its influence. In 1996, Alan Greenspan's warning of "irrational
exuberance" acknowledged, as the behaviorists do, that the average investor
is hardly the superrational "homo economicus" that mainstream economists
depict. In 2001, the young behaviorist Matthew Rabin won the John Bates Clark
Medal; last fall, the psychologist Daniel Kahneman, a forefather of behavioral
economics, was awarded the Nobel in economic science. And so it was
that the Boston Fed summoned the behaviorists to the Wequassett Inn in Chatham,
Mass. The conference was given the quaint title "How Humans Behave," as if
monetary policymakers had suddenly realized that, lo and behold, on the other
end of all that policy are actual people. The collection of mainstream economists
and central bankers would be the highest-level audience the behaviorists
had ever enjoyed, the best chance yet for their new thinking to hit the bloodstream.
From the outset the mood was civil, especially considering that the
behaviorists are essentially calling for an end to economics as we know it.
(As one economist grumbled, "What you have to understand is that behavioral
economics is attacking the foundation of what welfare economics is built
on.") So it was not surprising that some Fed elders seemed wary, as if they
were at a family reunion and welcoming a distant cousin about whom they had
heard only puzzling rumors. But with the economy stuck in a condition between
dismal and desperate, the behaviorists' timing could not have been better.
"All our models and forecasts say we'll see a better second half," Cathy
E. Minehan, president of the Boston Fed, said in her opening address. "But
we said that last year. Now don't get me wrong: mathematical models are wonderful
tools. But are there ways this process can be done better? Can we inform
the policymaker from 50,000 feet with wisdom gained on the ground, in the
human brain, or in the way humans make decisions and organize themselves?
I hope so." Ms. Minehan and her colleagues were particularly hoping
to learn why Americans save too little, acquire too much expensive debt and
perform such achingly self-destructive feats of portfolio management. The
behaviorists, for their part, were put in a tight spot: eager to prove themselves
but leery of overpromising. "Virtually everyone doing behavioral economics
agrees we should go slowly in advocating policy change," Mr. Camerer wrote
in the paper he presented. "Our thinking was also not designed to precisely
answer questions about welfare and policy, but this is a good time in the
intellectual history of the field to say something." Eldar Shafir,
who teaches psychology and public affairs at Princeton, began with a behavioral
economics primer. It was full of the anomalies the field is known for, including
the popular "6 jam-vs.-24 jam" experiment. In an upscale grocery story, researchers
set up a tasting booth first with 6 jars of jams, and later with 24 jars.
In the first case, 40 percent of the customers stopped to taste and 30 percent
bought; in the second, 60 percent tasted but only 3 percent bought. The point
is that too many options can flummox a consumer — and if 24 jars of jam pose
a problem, imagine what 8,000 mutual funds can do. Standard economics would
argue that people are better off with more options. But behavioral economics
argues that people behave less like mathematical models than like — well,
people. Among the behaviorists, there is the common sentiment that
economics has been ruined by math. "Neoclassical economists came along in
the mid-19th century and wanted to mathematize the new science of economics,"
said George Loewenstein, a professor at Carnegie Mellon University. "They
couldn't include `the passions,' or emotions, in their models, because they
were too unruly, too complex. But they also thought that the emotions were
unknowable." Mr. Loewenstein described how he and his colleagues want
to prove otherwise — that not only are emotions not unknowable but that when
it comes to money, they may be more powerful than math. This is why Mr. Loewenstein
studies how people make financial choices while they are experiencing various
degrees of sadness, hunger and sexual arousal. This is why Colin Camerer
has become a student of brain imaging, trying to identify where a subject's
brain lights up when, for instance, a lowball offer leaves him disgusted.
But the most radical idea presented at the conference belonged to
Richard H. Thaler. His paper, written with the legal scholar Cass R. Sunstein,
was called "Libertarian Paternalism Is Not an Oxymoron." Leonine and youthful
at 57, Mr. Thaler, who teaches at the University of Chicago, is widely considered
the founder of behavioral economics (and some say, its next Nobel winner).
He is more confident and, accordingly, more prescriptive than his younger
colleagues. "Behavioral economics offers powerful tools to achieve
policy goals," he told the conference. "And libertarian paternalism is an
attractive approach to solving policy problems. What else? I think the only
other alternative is inept neglect." Mr. Thaler has concluded that
too many people, no matter how educated or vigilant, are poor planners, inconsistent
savers and haphazard investors. His solution: public and private institutions
should gently steer individuals toward more enlightened choices. That is,
they must be saved from themselves. Mr. Thaler's most concrete idea is Save
More Tomorrow (SMarT), a savings plan whereby employees pledge a share of
their future salary increases to a retirement account. In test cases, the
plan has proved remarkably successful. "This was not pulled out of
thin air," Mr. Thaler said. "It was done using what I call first-grade psychology.
We knew this was going to work, no question." Indeed, the SMarT plan takes
advantage of behavioral economics' basic tenets: "loss aversion" (people
fear loss because it causes them far more pain than the pleasure they receive
from gain; but since the SMarT plan covers a future raise, they never feel
its loss); "status-quo bias" (since people are reluctant to change, the change
can be made for them); and "mental accounting" (people have a pressing need
to direct different streams of money into different "accounts"). Mr.
Thaler was followed by David I. Laibson, a young Harvard behaviorist who
also endorsed a paternalistic approach. "There are two enormous travesties
in the financial services industry," Mr. Laibson said. "One, people have
too much of their own company's stock, and two, mutual-fund management fees
are too high." His solution to the first problem: an automatic asset reallocation
to keep an employee from holding more than 20 percent of his portfolio in
company stock. "People could opt out," he said. "If you're crazy
enough to do that, fine, that's your right, but we'd certainly push them
down." His solution to the second problem: warning labels about management
fees, modeled after the surgeon general's cigarette warning. Mr.
Laibson's and Mr. Thaler's proposals were warmly received by the bankers
and mainstream economists. If this is behavioral economics, what's not to
like? The proposals seemed to be sound and not particularly invasive solutions
to Americans' troubling money habits. All the earlier talk of sexual-arousal
studies and brain imaging may have left them flat; but here were some real
action items. The behaviorists, most of whom are hardcore empiricists,
even felt comfortable enough to declare their own research wish lists. Dan
Ariely of the Massachusetts Institute of Technology trolled the room for
a good contact at the Internal Revenue Service (he wants to study the psychology
of tax cheats). Duncan J. Watts, a sociologist at Columbia University, half-jokingly
requested access to the phone and e-mail records of all Federal Reserve employees
(he is looking for good data to better understand how organizations behave).
The warm reception didn't mean wholesale conversion. When Jeffrey C. Fuhrer,
the Boston Fed's chief economist, was asked about Mr. Camerer's desire for
a new Economics 101 textbook, one that puts behaviorism at the center and
mathematical modeling on the fringe, he responded: "Yeah, that's his `I Have
a Dream' speech. I think that's still weeks off." Still, Mr. Fuhrer,
who organized the conference, was delighted with its outcome: "I think we
would have been crazy to expect we'd walk out of this conference and say,
`O.K., we're going to our next meeting, and now we know what to do because
these guys told us.' But having had these conversations, where people look
at economics from a different viewpoint, will we think a little differently
about how we do research and exactly which people we might talk to? You bet
we will." They may have little choice. As Frederick S. Breimyer, chief economist of the State Street Corporation in Boston, said, "We're looking outside the box because the box we've been looking inside is empty."
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