Friday, October 13, 2017

What Does a Faux-Nobel Prize Tell Us About Economic Policy?

by Neil H. Buchanan

"You can't beat something with nothing."  That adage is usually trotted out when someone wants to say that a purely negative argument is not enough to win, that is, that "merely" showing that someone else is wrong is somehow never sufficient to win a debate.

As such, the saying ought to be the opposite of a truism.  If someone makes a bad argument, the only thing necessary to beat that argument should be a clear refutation.  "I am a great deal maker," says a man.  "No, you make bad deals," you respond.  "Oh yeah?  Show me someone who makes better deals!"

As illogical as that is, it is surprisingly common for people to continue to accept bad claims until someone proves an alternative claim.  Criminal lawyers will tell you that sowing reasonable doubt in a jury's mind is almost never enough, because jurors want "a better story."  If the defendant is not the murderer, then who is?

One would hope that such mindlessness would not infect arguments among academic experts, but it does.  In particular, the field of economics has been dominated for decades by people who proffer a bad theory but who have thrived by saying, "Oh yeah, you say our theory's bad?  Where's yours?"

It is no small matter that that dominant theory is rigged to generate right-leaning policy prescriptions.  Combined with serious financial backing from conservative sugar daddies, the field of economics has been built upon a default theory that purports to prove Ronald Reagan's assertion that government is always the problem and never the solution.

There have, of course, been plenty of economists with orthodox training who have argued in favor or both micro- and macroeconomic theories that lead to centrist and liberal policies.  But it has always been true that such theories and policies are viewed with suspicion and must be ten times as strong to receive even one-tenth of the credibility that standard right-wing dogma receives by default.

Thankfully, economists have in recent years started to relent, and the world is becoming better for it.  The orthodoxy is at last starting to crack.  The interesting question is whether the orthodox theory is dying because of its own inherent weakness or because something came to replace it.  Did nothing beat something, or did something beat something?

I am thinking about this question because the Swedish Royal Bank has just completed its annual ritual of conferring its economics award, an award that is not a Nobel Prize but that carries high prestige.  Every year, conservatives and liberals look for validation in an award that is not a Nobel and really should not even exist.

This year, liberals are the ones who are smiling, because Richard Thaler won the award.  Why is that happy news for liberals?  Because Thaler has for years been a leading theorist and a popularizing voice of a field that is now known as behavioral economics.  Although the true pioneers of behavioralism were Daniel Kahnemann and Amos Tversky, Thaler's importance cannot be overstated.

What is the difference between behavioral economics and plain-vanilla (orthodox) economics?  Not to be too cute about it, but behavioral economics is different because it takes behavior into account.  But surely, one might say, that cannot be right.  How could regular old orthodox economics make predictions about economic activity without having a theory about human behavior?

The simple answer is that orthodox economics does start from a behavioral theory, known as "rational actor" theory, but that theory is ridiculous.  The theory is so ridiculous, in fact, that orthodox economists rarely even bother to claim that it is right.  "I'm not saying that people truly act as hyper-rationally as I must assume for purposes of building my economic model.  I'm just saying that it's a better unrealistic theory than all of the others."

In other words, "You can't beat something with nothing."  Orthodox economists want to claim that theirs is the default "something," and unless something else comes along that clearly dominates their theory, they win.

Is the behavioral economics school that new something?  As the business columnist for The New York Times put it in describing Thaler's work, behavioral economists have shown that people "consistently behave in ways that defy economic theory."  (That the columnist did not feel the need even to add "orthodox" before the words "economic theory" tells us everything we need to know about the dominance of the hyper-rational theory that behavorialists are criticizing.)

Thaler and the behavioralists have offered a large number of interesting insights, all of which are based on the "well duh" truth that people are not hyper-rational.  What makes those insights nontrivial is both that they are grounded in psychological principles (individual and social) and that they can lead to very different policy prescriptions -- prescriptions that often (though not always) are politically non-conservative.

Liberals are therefore pleased with this year's prize.  Both Paul Krugman (himself a prior winner of the faux-Nobel, whose award delighted liberals) and David Leonhardt (a non-economist who has carved out a career as an economics journalist and is now a columnist for the op-ed page of The New York Times) expressed delight at Thaler's award.

I am a liberal, too, and as far as it goes, I am perfectly happy to celebrate Thaler's justifiable renown.  Using behavioral concepts to devise policies that overcome myopia, framing biases, and other less-than-rational human psychological defaults, Thaler and his associates have improved our retirement savings incentives and offered other useful ways to move people toward better outcomes than they might otherwise achieve.

As an aside, I should mention that some conservatives still insist that there is no such thing as non-rational economic behavior.  Everything that people do can be rationalized after the fact, such that what looks like irrational behavior can always be explained as merely "rationally optimizing a different set of target variables."  The most infamous example of this is the theory of "rational suicide" (criticized here).

That tautological approach is merely a different way of saying that everything always happens for the best in this best of all possible worlds.  If it is not already happening, says the theory, people must not want it to happen.  The government can only make things worse -- but again, that is by assumption, not the result of rigorous proof.

For those who prefer not to assume the problem away, however, behavioral insights are a welcome addition to the field of economics and especially to discussions about possible policy choices.  We are certainly enhancing the range of possible actions once we allow ourselves to notice that human beings are human.

Even so, it is far too easy to overstate the significance of behavioral economics.  Four years ago, I wondered aloud (here and here) whether behavioral economics had "jumped the shark" and amounted to little more than a collection of interesting observations.  The possible implications of behavioral economics are so nonspecific -- often pointing in radically different directions -- that it has become difficult to draw general lessons from particular behavioral insights.  (OK, people have loss aversion.  What does that tell me about the minimum wage, or interest rates?)

The short answer was that we are better off in a world with behavioral economics than in a world without it.  Even though it is true that behavioral economics is not adding up to much as a theory, it is at least a collection of convincing objections to orthodox assertions of hyper-rationality and the conservative conclusions that flow therefrom.

It is, therefore, not quite right to say that behavioral economics is a "nothing" in the context of "beating something with nothing."  Thaler's faux-Nobel is a recognition of quite a large number of things that have enhanced our knowledge of the policy universe.

Even so, the success of behavioral economics still boils down to a critique of the orthodox theory.  It is not a theory of its own.  Indeed, as Michael Dorf insightfully argued about Thaler's work, behavioral economics is not truly a challenge to economic orthodoxy at all, because it does not challenge the notion of what counts as economic rationality.

The behavioralists, after all, argue that there is a "right" -- or at least a better -- way for people to behave, and that right way is to be in some sense less human and more rational in the orthodox sense.  Only then will people overcome their irrational defaults and, for example, save enough money for retirement.

So perhaps the question is not whether behavioral economics is a something or a nothing that has beaten the something of orthodox economics, but instead the question is whether orthodox economics has truly been beaten.  It certainly seems battered, and there are plenty of holes in the orthodox facade that we did not see before Thaler and his crowd came along, but how badly has orthodoxy been hurt?

As Dorf's column reminded us, Thaler's frequent co-author Cass Sunstein has done a great deal of work that undermines economic theory in a fundamental way.  As I have also written in many, many columns, economic theory (especially in its politically conservative manifestation) justifies its outcomes by taking as given a set of arbitrary choices about the proper baselines of legal rules, the distribution of wealth and other advantages, and so on.

To use one of the more extreme examples, if slavery is legal, then banning slavery will be inefficient; but if slavery is illegal, then enslaving a person will be inefficient.  That logic carries over to questions about the default baselines for contract law, property protections, and on and on.

And that is a much deeper way in which a nothing can beat a something.  If a person says, "I can use government to move us to the 'efficient' policy outcome that we would (and should) see if everyone were rational," she is a behavioralist.  If, on the other hand, a person says, "There is no such thing as efficiency because a 'no government' baseline cannot exist," she is saying something much deeper.

As a theory, orthodox economics did not need to be beaten, because it is not a theory at all.  It is built on a shifting and opportunistic set of baselines that (by design) pushed us relentlessly toward a "laissez-faire" default.  As a dominant paradigm, however, orthodox economics needed to be beaten, because its policy conclusions were thought to be obviously correct.

There is a lot to like about behavioral economics.  Even though it does not add up to much in the way of a theory, it has done a lot of damage to a non-theory that never should have been elevated to its position of primacy in the first place.  Perhaps the lesson is that you can beat something with nothing, so long as you have a whole lot of it.

14 comments:

David Ricardo said...

As a recovering economist (the emphasis on mathematical modeling to the exclusion of everything else really made economics not only unintelligible but also irrelevant) who fled to finance, quantitative methods and tax policy/analysis I view the behaviorists as the only road that can restore economics to relevance.

A major difference between the orthodoxy and the behaviorist theories is that the orthodox consider the
theory proven if the mathematics work. That observation and empirical results do not conform to the theory simply means the empirical results are wrong, people are not behaving as they should be. The behaviorists have adopted the rather obvious approach that if individuals behave in a certain manner it is the job of the economists to model and explain that behavior.

The crushing example with respect to the triumph of behaviorists over orthodox is the often cited opt in/opt out issue which Mr. Buchanan refers to with respect to retirement savings. Orthodox economics would say for example that it is irrelevant how enrollment in a 401k plan is set up. It should make no difference if eligible participants are not included unless they actively do so (opt in) or if eligible participants are automatically enrolled and stay in the 401k plan unless they act to leave the program (opt out). So since the results are the same under opt in or opt out, (those who want to join the plan do so and those who do not want to join the plan do not do) it should make no difference if a firm adopts opt in or opt out.

Unfortunately for the orthodoxy, this is a testable hypothesis. And of course the results show that opt out results in higher enrollment than opt in. (Game, set and match to Thaler and Susstein). Other empirical examples abound, for example raising the payout on a lottery from say $50 million to $500 million results in much greater participation even though the change in the odds of winning (effectively zero in both cases) does not change. A rational economic person who does not buy a $50 million lottery ticket will not buy a $500 million lottery ticket. That people do not conform to this behavior simply means the orthodoxy is wrong, not that people are stupid.

My favorite Tversky anecdotes are these two. The first is the famous Tversky IQ test which consists of the following. The shorter the time it takes for a person to realize that Amos is smarter than he or she is the higher their IQ. The second is when Tversky said 'My colleagues, they study artificial intelligence; me I study natural stupidity”. It is assumed he was at least in part talking about orthodox economists.

Shag from Brookline said...

Recall that "Seinfeld" was a TV show about "Nothing." But it was entertaining. What about a TV show about "Something" like "The Apprentice." Reruns of Seinfeld remain entertaining. "The Apprentice" is presently governing, and like the TV reality show people are being fired. But the current version of "The Apprentice" is not very popular. The Constitution handles the unpopular by periodic elections and rarely by impeachment. So a reality TV show becomes a reality but "We, the People," don't have the power of a TV network. This may be an example of behavioral politics as opposed to rational politics, assuming the latter ever existed. Come to think of it, we've had political dysfunction for quite some time.

Query: Do legal theories fair better than economic theories? How well are legal theories tested in comparison with the testing of theories in the hard sciences? In legal academia it is said that it takes a theory to beat a theory. (Aside: How many theories of originalism are there to date, beating on each other?)

Perhaps Porgy and Bess' "I've Got Plenty of Nothing" would be an appropriate cite for Neil's closing sentence.

Joe said...

Seinfeld was of course about something.

greg rubin said...

I am not quite sure that behavioral economics is a 'nothing' so much as it is a nacient theory. In time it seems possible to model irrational behavior and update the models to account for it, at least to some degree. It will take some time to do the research to model such behaviors but I can't think of any reason that it couldn't happen.


Keeping with David's example it should be possibly to model the rate of op-in versus op-in models for retirement savings. In fact much of that data probably already exists. It would just take access to the HR data of a couple of large companies that work in alternative ways. Then some serious number crunching to identify the rates, and how those rates vary across income, marital status, number of children, etc. Which likely most HR departments already have in their databases anyway.

What may be harder is to even identify all of the ways that irrational behavior needs to be modeled in order to update classical economic theory. But that is really something that science is pretty good at flushing out given time and resources to investigate.

Shag from Brookline said...

How about modeling Trump's irrational behavior or is that an ongoing project?

David Ricardo said...

Greg's comment is a good one and illustrates one point, that classical economics is more accepted because the theory can be more easily modeled and 'proven' mathematically as opposed to being realistic. It is akin to the old story of a person who lost their wallet and is looking for it. A friend approaches and helps and when they don't find the wallet the friend asks “Are you sure this is where you lost it?” The person replies, “I lost it a block over, but the light is better here”.

Models can be developed for behavioral economics and empirical data can be found to test the hypotheses. And good public policy decisions are at stake as Tversky Kahneman, Thaler and Sunstein have shown. Consider the just announced policy whereby employers do not have to include free contraceptive coverage in their health plans.

Traditional economics would tell us that given the relatively small cost of purchasing contraception vs the high economic, physical and emotional costs of an unwanted pregnancy ending free contraception coverage should make almost no difference with respect to contraception usage by women. But behavioral theory would say that will not be the result because of various behavioral characteristics identified by the quartet above and others which influence decisions.

If they are correct one result of the new policy will be an increase in abortions. We don't know if the number will be 50,000, 150,000 or 500,000 but if (when) the behavioral economics is proven to be correct the administration's policy will have been a terrible tragedy, and an even more terrible tragedy in that understanding behavioral economics could have prevented it.

Shag from Brookline said...

I'm wondering if there is a ____ step process for "a recovering economist" that might include the fleeing steps that David took. David stresses "hypotheses" rather than "theories," which I assume is intentional, whereas many refer to "economic theory." In my view, attempts in the soft sciences to emulate the hard sciences respecting a theory are weak. Hard sciences over time can go through the route of hypothesis to theory to a scientific law, with many difficult hurdles to overcome along the way. The route of a soft science may be difficult getting to the theory stage and near impossible to get to a soft science law.

Irrationality is here to stay and good public policy may be needed to prevent terrible tragedy. But can we expect legislatures to act rationally in arriving at such good public policy? The political dysfunction of the 21st century suggests not.

An area of irrationality in voting was addressed in "What's The Matter With Kansas?" well before the 2016 campaign. Behavioral voting against one's economic interests can be fueled by PR campaigns funded by dark money. Is this a variation on behavioral economics? Am I being irrational in asking?

greg rubin said...

David,

It's interesting that you used birth control and abortion rates and free birth control because we actually know what the effect of those policies are. Thanks to a study in Colorado a few years ago that tracked the effect of long acting birth control we found that the rate of unwanted pregnancies went down roughly 50%, and the rate of abortions by about 50% (I would need to look it up to pull the exact numbers but its in that range). So for the employers who opt out of providing free birth control we should expect to see roughly the same.

However it will be skewed somewhat. The Colorado study was means tested, so involved women for whom the cost of birth control may have been substantial, while this policy will of course effect those with jobs, and more narrowly jobs that provide health insurance. So the rate of decline will likely be less, how much less, meh who knows. But I would love access to the HR reports of the companies involved to see.


But I do think you do a disservice to traditional models of economics. Sure we know that is assumes perfectly rational actors and thus never actually describes reality, but it dos do so with enough accuracy to make substantial predictions and allows for a range of error. Much like predicting hurricanes, sure we can't predict where thy will hit within a mile, but the predictions are accurate enough to make policy decisions based on them.

It's more like saying I lost my wallet and I am pretty sure it was somewhere on these two blocks but I don't know where more precisely so I am starting by looking in the well lit areas first. Long term I think the irrationality models will be able to be modeled plugged into rational models and allow for even greater accuracy.

Shag from Brookline said...

I'm reminded of President Truman's search for a one-handed economist.

David Ricardo said...

Me too.

With respect to theory and hypotheses and hard science and soft science let me explain and give an example. In my world hypotheses are derived from theory. So the economic theory of rational economic actors can produce hypotheses about behavior with which to test the validity of that theory. Here is one from my experience as a financial and tax consultant.

An investor has a choice between two bond portfolios that are equal in terms of risk and duration. Portfolio A is made up of tax exempt bonds. Portfolio B is made up of taxable bonds. Obviously the pretax yield on Portfolio B is greater than the yield on Portfolio A. A rational investor would determine the after tax yield on B, compare it with A and select the portfolio with the highest yield post tax.

In my tax planning and strategy practice I encountered a number of high net worth investors, some of whom had a tax exempt portfolio, Portfolio A. After analyzing the securities I was able to present them with an alternative portfolio, Portfolio B which was fully taxable but for the marginal tax bracket of the investors had an after tax return greater than A. For these investors the higher after tax return was in the high five figures to low six figures (these were rich people). After presenting B to the clients I sat back and waited for the kudos and the praise to pour in. Instead almost all of the reaction was negative, and in one case abusively so. Only one client out of many changed from A to B.

Why?

It turned out these investors hated government and hated paying taxes. Their hatred was so great that they were willing to take a lower after tax return on the tax free portfolio than they could have received on the taxable portfolio just so they could lower their tax bill. For one investor his tax bill was very small and when shown how much his tax bill would be with the taxable portfolio, well let's just say it wasn't a pleasant conversation. The fact that he would have more money after tax with the taxable portfolio was simply not relevant to him.

This illustrates a key point of Tversky et. al. Psychological factors enter into economic behavior and in some cases dominate. Now as far as orthodox economics assuming that rational economic behavior is close enough, yes, in some cases that works. But in some cases it does not.

Take monetary policy for example. A large number of economists believe that monetary policy must be symmetric. If decreasing the supply of money and higher interest rates leads to contraction, increasing the supply of money and lowering interest rates must lead to expansion. The real world , i.e. data and analysis and experience shows that this is false. Any doubts, look at 2009-2013. Take tax policy for example. Raising taxes must result in a contraction of the economy. The real world , i.e. data and analysis and experience shows that this is false. Any doubts, look at 1993-2001 or 2013-2017. Take pricing for example. I do volunteer work for a charity thrift store that sells among other things donated used appliances. When the store appliance inventory increases too much the store cuts prices to sell more units. The result, it sells less units. Why? You figure it out.

Sometimes orthodox economics works and produces good policy. But many times it does not and produces bad policy. The problem is the orthodox economic group refuses to recognize the exceptions, numerous though they may be. Behavioral economics as supported by Tversky and his cohorts says base your beliefs, decisions and actions on data from the real world. (Mayor Michael Bloomberg: “In God we trust, all others bring data”) and try to understand what the data is telling you. Orthodox economics says that if the real world contradicts the models, the real world is wrong.

greg rubin said...

David,

I think it came across as though I was disagreeing with you, in fact the opposite. I have zero doubt that classic economic theory is broken, and broken substantially. In my field (attorney) the surest way to never get clients is to sell yourself on price. No one wants to walk into court thinking their attorney is the cheapest they could find. As you mention there are countless examples of this. My point however is that much of this behavior can be modeled. Because while people may act irrationally, they tend to act irrationally in the same ways over and over again.

Shag from Brookline said...

David's reference to investors who hated government and hated paying taxes brought to mind what Justice Oliver Wendall Holmes, Jr. said about paying taxes and civilization. I did some Googling and came up with a website that responded to an inquiry regarding this inscription on the exterior of the IRS building in DC: "Taxes are what we pay for a civilized society." The website explains by pointing to various quotes attributable to Justice Holmes. It makes a good read. Here's the URL:

https://quoteinvestigator.com/2012/04/13/taxes-civilize/

I recently posited whether one could make a voluntary contribution to the United States and then take a charitable deduction for the contribution on one's income tax return. No one bit. My thought might be irrational, but I'm with my homey Justice Holmes.

And Greg's closing sentence at 3:16 AM brought to mind Einstein's definition of insanity.

I've got to go back to bed.

Shag from Brookline said...

Speaking of taxes, Paul Krugman posted at his NYTimes blog yesterday "LIES, LIES, LIES, LIES, LIES, LIES, LIES, LIES, LIES, LIES" enumerating 10 lies, with some interesting graphs. Is lying over and over again irrational or insanity?

David Ricardo said...

Me too