Behavioral Economics and Policy

Last month, Rick Montgomery wrote an interesting article, “Behavioral Economics Is Moving from Theory to Policy,” for the Kansas City Star.  Here are some excerpts.

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As the economy sinks and investors buckle over, the behavior buffs are rising up.

From the lesser-appointed corners of academia, psychologists, sociologists and a youthful breed of economists scoff at the revered mathematical models that have driven economic thought and snared Nobel Prizes.

These preachers of “behavioral economics,” including some on President-elect Barack Obama’s economic team, argue that humans cannot be relied upon to obey the efficient, orderly tenets espoused by free-market thinkers.

Chief among the old-school rules is the assumption that we act rationally with money.

“That’s absurd, counterfactual . . . and now they’ve created a catastrophe,” said William Black, who teaches economics and law at the University of Missouri-Kansas City.

Until now, policymakers showed slight regard for the growing field of study into how mortal gaffes and greed intersect with financial decision-making in ways that can punish us all.

Now some close to Obama suggest government’s role is to “nudge” Americans into behaving in economically smarter ways.

“We need a bit more ‘Psych 101’ in addition to ‘Econ 101’ in the design of public policies,” blogged Peter Orszag, the next chief of the Office of Management and Budget, who just turned 40.

Some traditional economists might ask, “And how do you intend to calculate the effects of herd mentality, blind faith or self-destructive foolishness when dealing with a mortgage broker?”

They might cite the gospel that free markets, like celestial bodies in orbit, move in rational and self-correcting ways. Knowing that, who would ever fall for the gravity-defying performance reports of fund manager Bernard Madoff, who claimed double-digit returns year after year after year?

Human beings, that’s who — now shorn of $50 billion.

In October, behavioral scholars were triumphant when the very oracle of the slide-rule set, Alan Greenspan, delivered in Congress what some called a requiem for decades’ worth of economic teaching.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity — myself, especially — are in a state of shocked disbelief,” the former Federal Reserve chairman conceded.

Why so shocked?

As many see it, a star of Economics 101 known as the “rational actor” abandoned the stage and left markets a mess.

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Across America, collegiate quarrels have been building ever since economists began calling themselves scientists.

Channeling Isaac Newton, those 20th-century purveyors of empirical truths felt they needed formulas to forecast outcomes and solve economic riddles.

Oh, please, murmured many psychologists, sociologists and political scientists. To them, economists were trying to elevate themselves above the murkier, “softer” sciences.

The creation in 1969 of the Nobel Prize in Economic Science put monetary thinkers in the league of the great laureates of medicine and physics.

The second recipient of the prize was Paul A. Samuelson. His 1947 book, Foundations of Economic Analysis, was among the first to pitch sophisticated mathematics as the key to understanding and addressing problems.

Samuelson is 93 now. And what irritates him about the debate over behavioral economics is its either-or tone.

Most of the time, free markets do follow rational, predictable rhythms, Samuelson told The Star. But history has shown that bubbles can build and “the slide-rule guys can’t smooth out those bubbles.”

“A hopelessly addicted centrist (favoring) limited, sensible regulation,” Samuelson blamed “eight terrible years of deregulation” that saw some of Wall Street’s brightest financial engineers tiptoe from the rational realm to the reckless one.

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You can read the entire article here.  For a list of related Situationist posts, click here.

To read some longer law review articles detailing the history of the “competition” between economics, economic behavioralism, and situationism, check out “Legal Academic Backlash: The Response of Legal Theorists to Situationist Insights” (Emory Law Journal, Vol. 57, No. 5, 2008) available on SSRN, “The Situational Character: A Critical Realist Perspective on the Human Animal” (Georgetown Law Review, Vol. 93, 2004) available on SSRN,” and “Taking Behavioralism Seriously: The Problem of Market Manipulation” (New York University Law Review, Vol. 74, 1999) available on SSRN.