How far will behavioral economics bring us?

Not very far, according to George Loewenstein, one of the field’s pioneers.

But the field has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address. Indeed, it seems in some cases that behavioral economics is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics.

Behavioral economics should complement, not substitute for, more substantive economic interventions. If traditional economics suggests that we should have a larger price difference between sugar-free and sugared drinks, behavioral economics could suggest whether consumers would respond better to a subsidy on unsweetened drinks or a tax on sugary drinks.

But that’s the most it can do. For all of its insights, behavioral economics alone is not a viable alternative to the kinds of far-reaching policies we need to tackle our nation’s challenges.

Loewenstein’s article is motivated by his observation that every week, we see books and articles that talk about how irrational decision making can have implications on our life. Indeed, apart from some exceptional ones, many books and articles simply repeat what everyone already knows about how irrational we really are. The book review I spotted on Amazon probably describes better some of the books out there:

This book is a feature length article expanded into a book. After the first 30 pages, I felt like the dead horse was being kicked, and kicked, and kicked, and kicked… and it was dead. I get it… People make bad decisions, and have bad beliefs they cling to. Enough already. I tried reading every tenth page, and it was just the same stuff.

Of course we must remember that behavioral economics is a relatively new – and fertile – field. At this point of time however, I think what we require more is the application of behavioral economics. Richard Thaler and Cass Suntein’s Nudge does a great job on proposing how its findings can be applied in public policy to achieve what they call “libertarian paternalism”. Libertarian paternalism refers to fulfilling the demands of citizens to have freedom of choice (hence libertarian), yet subtly nudging people towards making choices that are good for them (hence paternalism).

An example would be the urinals below – by the way Terminal 3 of Changi Airport has toilets with urinals that have flies etched on them – through the design they prompt males to aim better, reducing spillage.

It would be wonderful if we could see more books like this instead of those that simply repeat the same old experiments that reveal human irrationality.

We might go even further if behavioral economics starts integrating formally with macroeconomics. At present, financial mathematics is receiving plenty of flak all around for its contribution to the financial crisis. Economyths: Ten Ways Economics Gets it Wrong put me to sleep every single time I read it, but its main premise is that economics has hit a brick wall because of how economists have incorporated mathematics based on unrealistic assumptions to make the field more rigorous, like a science.

Nassim Taleb’s Fooled by Randomness very severely denigrates the field of financial mathematics, calling quants and traders alike arrogant in their belief that risk can be systematically managed. For that matter, Taleb harshly criticizes the entire field of economics – the proof being his mockery of the Nobel Prize in Economics – save for the more realistic behavioral economics. In How Markets Fail*, John Cassidy calls traditional economics “utopian economics”, and behavioral economics “reality-based economics.

All these make me wonder about the future of economics and finance. While debates still rage on in these fields, what are we as students going to be taught? Are we going to continue to rely on such theories as the efficient markets hypothesis and capital asset pricing model? How much of the behavioral approach should we be exposed to?  One thing’s for sure: all this uncertainty makes for a very exciting time to learn finance.

*How Markets Fail is a very, very illuminating read of an overview of economics.

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