Kenneth Arrow on Behavioral Economics, etc.

A few weeks ago I blogged about Conor Clarke's insightful interview with Paul Samuelson. Well, Mr. Clarke is back at it, and he recently conducted an interview with Nobel prize-winning economist Kenneth Arrow (part one here, part two here, and part three here). Arrow is best known for his contributions to general equilibrium analysis, welfare economics, and Arrow's Impossibility Theorem. The interview addresses subjects such as healthcare reform, behavioral economics, and climate change. Here are a few things I found interesting (interview questions are bolded):

What do you think of behavioral economics?

Yes, there is a tendency to go to these psychological arguments. But my problem with these arguments is not that they are wrong -- though sometimes there are wrong -- but that they are not helpful.

Why?

They don't predict anything!

I agree that behavioral economics is only useful if it increases the accuracy of predictions made by economists (see here and here). Nevertheless, I wouldn't go so far as to say that behavioral economics doesn't "predict anything." Behavioral economics does a good job of predicting how people make retirement decisions (hint: they follow the status quo, so default rules are exceptionally important determinants of behavior).

Back to the interview - Arrow on the uncertainty surrounding climate change:

The treatment of uncertainty [with climate change] strikes me as one of the most confusing things about climate change. . . . But with climate change there is an awful lot at stake! And the time horizon is long, and you have the risk of these incredibly high cost but low probability events...

Well, the least that can occur still looks pretty bad, and I don't want to overdo the uncertainty question. I think that, even if you take a very conservative point of view, things are bad. 150 years from now, the average person will be a lot poorer then they would be otherwise be.

On health care costs:

The basic reason why health costs increased is that health care is a good thing! Because today there is a lot more you can do! Consider all these expenses that are diagnostic. Cat scans, X-rays, MRIs and now the proton-powered whatever-it-is. Something that is the size of a football field, cost $50 million, and has all sorts of diagnostic powers. A lot of these technologies clearly reveal things that would not be revealed otherwise. There's no question about it. Diagnostics have improved. Technology has improved. You know, sending things through your blood stream to help in operations, instead of cutting you open. It's incredible. But these things are costly. But for older people longevity is increasing by a month each year. Now, whether that creates other problems with retirement and social security is another question. But, nevertheless, preserving life is a good thing.

On the erosion of professional standards:

And if one explanation is the professional standards, why do you think the professional standards have changed?

Sometimes I think it's because of the Chicago School.

I'm not sure if the last one was a joke, but blaming the Chicago School for the decline in professional standards seems a bit over the top. Still, I would definitely recommend reading the entire interview.

Posner v. Thaler - Behavioral Economics

Richard Posner, one of my academic heroes (see here and here), recently criticized the Consumer Financial Protection Agency Act of 2009 in the Wall Street Journal. Although I don't know the details of this act, I was somewhat surprised that in his editorial, Posner went further and criticized behavioral economics and Richard Thaler, one of behavioral economics' strongest proponents:

The plan of the new agency reveals the influence of “behavioral economics,” which teaches that people, even when fully informed, often screw up because of various cognitive limitations. A leading behavioral economist, Richard Thaler of the University of Chicago Booth School of Business, wrote “Nudge: Improving
Decisions About Health, Wealth, and Happiness” last year with Cass Sunstein, who is President Barack Obama’s nominee for “regulatory czar.”

Mr. Thaler, whose views are taken seriously by the Obama administration, calls himself a “libertarian paternalist.” But that is an oxymoron. He is a paternalist with a velvet glove—as the agency will be. Through the use of carrot and stick, the agency will steer consumers to those financial products that it thinks best for them, whatever they naïvely think.

. . .

Behavioral economists are right to point to the limitations of human cognition. But if they have the same cognitive limitations as consumers, should they be designing systems of consumer protection?

Two things struck me about this argument. First, libertarian paternalism, at least as it is defined by Thaler and Nudge co-author Cass Sunstein, is not an oxymoron. They argue this point forcefully in an article called "Libertarian Paternalism Is Not an Oxymoron." This article is one of the forces that converted me to the importance of behavioral economics. Among other things, the article argues that regulators will inevitably influence behavior, since default rules (such as voluntary or mandatory enrollment in retirement plans) affect decisions.

Second, although it may have been tongue-in-cheek, I am surprised by Posner's claim that regulators, because they have cognitive limitations, cannot encourage people to make better decisions. This is a poor argument. Regulators have time to make considered decisions, many consumers do not. Regulators are specialists, most consumers aren't. I was pleased to read that Thaler, in a response to Posner, makes very similar points:

The premise of behavioral economics is that humans are not perfect decision-making machines. We are busy and distracted. We have fields that we know well, but are amateurs in most other domains. If our car breaks down, we go to a trained mechanic. Even the best mechanics will make some mistakes (they are human), but for most of us they still have a better chance of getting our cars to work than doing it ourselves.

How Far Should We Take Paternalism?

In a Wall Street Journal article, Todd Zywicki highlights an analogy made by Elizabeth Warren, a Harvard Law professor:

[C]onsumers cannot buy a toaster that has a one-in-five chance of exploding, but they can get a subprime mortgage that has a one-in-five chance of ending in foreclosure.

I see one big problem with this analogy. A toaster would explode because of shoddy manufacturing - unless, of course, you have a child who puts his toys in the toaster. It is the manufacturer's fault when the toaster explodes.

On the other hand, in almost all cases mortgages end in foreclosure because of consumers' mistakes. It is not the bank's fault that the mortgagee lost his or her job (speaking of any single bank), it's not the bank's fault the mortgagee used too many credit cards, it's not the bank's fault the home lost value, and it's not the bank's fault mortgagees bought multiple investment homes. Consumers lived on credit because government tax breaks and low interest rates gave them a strong incentive to live accordingly. A foreclosed mortgage is nothing like an exploding toaster.

To be fair, many mortgage brokers were disingenuous in how they presented loans. I'm thus in favor of behavioral economics-type disclosure regulations. But I don't think the government should, in this case, impede freedom of contract. As Zywicki writes:

Treating all consumers as hapless victims rather than recognizing that many consumers rationally respond to incentives is a recipe for unintended consequences. It can lead to counterproductive regulation that makes loans more expensive and harder to get.

We Need Accurate Predictions!

Brad Delong, a Berkeley economist whose work I generally respect, reviewed Judge Richard Posner’s book A Failure of Capitalism. The review is very critical of both the book and of the Chicago school of economics. The Chicago school is a branch of economics that has been quite influential over the past half century. The intellectual founder was the late Milton Friedman.

The Chicago school is deductive in its results; virtually all its theories rely on the assumption that consumers and producers are rational. To Chicago-school economists rationality means that consumers use all available information to make choices that maximize subjective well-being. While Chicago-school economists do not suppose that people are all knowing, they do assume that people are generally correct in their beliefs and assumptions about the future. Critics of the Chicago school typically overstate the assumptions of its adherents, claiming that such economists envision people as being omniscient.

Milton Friedman responded to some of these criticisms in an essay, "The Methodology of Positive Economics." According to Friedman, the way to test the validity of models is by analyzing the accuracy of their predictions, not by the accuracy of their assumptions. Thus, although people may not be as rational as the Chicago school supposes, Chicago-school theories are valid if they make accurate predictions. The reason that the Chicago school has been so successful is that its models have been confirmed by a wealth of data.

Furthermore, according to Friedman – and the principle’s embodied by Ockham’s razor – if multiple models make equally accurate predictions, the best model is the simplest. These views are not exclusive to economists: the great theoretical physicists Stephen Hawking makes similar claims in A Brief History of Time.

Anyway, back to Delong –

The review is based on an analogy comparing (a) Chicago-school adherents to 17th Century Jesuits and (b) enlightened economists (presumably behavioralists who acknowledge irrationality) to Copernicans. Jesuits believed that the sun revolved around the earth. Copernicus’s model claimed otherwise. Despite mounting evidence, the Jesuits clung to their beliefs by developing increasingly complicated models. Nonetheless, the Jesuit models couldn't predict planetary movements as successfully as Copernicus's simple but elegant model.

The Jesuit/Copernican analogy is the most ill-advised part of the review (other than perhaps DeLong’s failure to define rationality, as Posner points out in a response). The reason is that in economics, it is the behavioralists who are proposing increasingly complicated models and assumptions. Furthermore, with a few exceptions the behavioralist models are not able to predict behavior as effectively and accurately as rationality-based models. The assumptions of behavioralist models are often vague, ad hoc, and inconstant from model to model. Behavioral predictions are generally non-quantifiable and difficult to implement in non-laboratory settings. Until behavioral economics can make predictions that are more accurate than neoclassical predictions, its claims of irrationality will be meaningless.

This post may seem surprising, given the blog subtitle. I indeed identify as a behavioral economist - or rather as an economist who dabbles in behavioral research. In my view behavioralism can offer useful insights into economic decision-making. Nevertheless, behavioral economics will be little more than an interesting footnote until it can consistently make accurate predictions.

In a later post I'll identify some behavioral predictions that are more accurate than neoclassical predictions.

The Purpose of Behavioral Economics

Professors Christine Jolls, Cass Sunstein, and Richard Thaler published a great 1998 article on behavioral (law and) economics in the Stanford Law Review. One quote strikes me as being particularly insightful:

The project of behavioral law and economics, as we see it, is to take the core insights and successes of economics and build upon them by making more realistic assumptions about human behavior. We wish to retain the power of the economist’s approach to social science while offering a better description of the behavior of the agents in society and the economy. Behavioral law and economics, in short, offers the potential to be law and economics with a higher “R2”—that is, greater power to explain the observed data. We will try to highlight some of that potential (and suggest cases where it has been realized) in this article. (p. 1487)

Proposing more realistic economic assumptions is a pointless exercise unless the assumptions increase the ability of models to predict. Thus, the proof of behavioral economics is, as they say, in the pudding.