From the Times Literary Supplement, June 12:
Mainstream economic
theory assumes that agents have stable, well-defined preferences and
make rational choices consistent with those preferences. Behavioural
economics, which introduces a social and psychological dimension to
describe how people really behave, has long challenged such assumptions.
At first glance, this upstart discipline
appears to have enjoyed considerable success. Three of its leading
exponents – Daniel Kahneman (1934–2024), Robert Shiller and Richard H.
Thaler – have received Nobel prizes in economics, and each has written a
bestselling book popularizing his work. Behavioural psychology has also
influenced public policymaking across the western world. Yet, as two
new books reveal, this discipline has had little impact on how economics
is taught. At the same time, the success of so-called “nudge” policies
appears to have been overstated. More troublingly, during the pandemic
they served as a propaganda tool for installing widespread fear in the
populace, with little or no consideration for the harmful side effects.
Thaler’s The Winner’s Curse (1992),
a landmark publication of behavioural economics, has been reissued in a
new edition co-authored with Thaler’s colleague at the Chicago Booth
School of Business, Alex O. Imas. The original book identified a number
of “anomalies” that are at odds with the assumptions of modern economic
theory, most of which are republished here with updates. For instance,
economists teach that agents act rationally to maximize expected gains.
Yet Thaler showed that winners in competitive auctions have a systematic
tendency to overpay. The original finding related to successful bidders
for oil leases and was confirmed in classroom experiments. The “curse”
was later found to hold for winners in contests for corporate control
and publishers’ bidding wars for new books.
Another anomaly revealed that people
favour co-operation and are willing to experience losses in order to
ensure a fair outcome. This contradicts the notion that economic agents
are driven by selfish rationality. A further famous anomaly discovered
by Thaler involved him handing out mugs to some of the students in his
class. The students who received the mugs turned out to value them more
highly than those who didn’t. This finding he called the “endowment
effect”. Then there is the question of the price of time. Economists
assume that people employ the same discount rate to benefits (or costs)
that accrue over different periods of time (what is known as the
“exponential discount model”). But Thaler and his one-time collaborator
George Loewenstein showed that actual behaviour is often not
time-consistent: we tend to be more impatient for, and thus to
overvalue, immediate rewards compared to deferred ones (what is called
“quasi- hyperbolic discounting”).
Economists also teach that money is
fungible – that one dollar is exactly the same as another. But Thaler
showed that decisions about spending or saving can be influenced by
where the money comes from: earned income and dividends are more likely
to be consumed than capital gains and other windfalls. “Mental
accounting” explains why some people keep money earning little interest
in a savings account while borrowing at usurious rates on their credit
cards.
In the first edition of The Winner’s Curse,
Thaler expressed the hope that his collection of anomalies would result
in a “new improved version of economic theory”. But no paradigm shift
occurred. This new edition laments that “mainstream economics textbooks
remain firmly anchored in the standard neoclassical framework”. The
reason for this lack of change is partly because, as Thaler and Imas
suggest, conventional economics, which assumes consistency and
optimization by economic agents, is mathematically tractable and
provides clear predictions, while behavioural anomalies are difficult to
model.
But that’s not the whole story. The legal
scholar Richard Posner long ago dismissed behavioural economics as mere
“cognitive quirks”. In the grand scheme of things, he argued, their
significance is easily overstated. For example, while Thaler’s students
may exhibit an endowment effect when handed a mug in the classroom, this
finding doesn’t hold for professional traders. An oil company that
persistently pays too much for drilling leases will eventually be driven
out of business. Publishers compensate for the winner’s curse in their
bidding wars by paying out a miserly share of sales receipts to their
other authors. Companies that appear to overpay for acquisitions often
use their own overpriced shares in payment, as was the case when the
internet high-flyer America Online acquired the media giant Time Warner
in 2000.
As the behavioural economists well
understand, apparent violations of economic theory can arise because of
the difficulty of exploiting market mispricings. Until five years ago,
the energy company Shell was listed under different corporate entities
in Holland and the UK. The Dutch and British shares often traded at
different prices despite having the same fundamental value. This was a
clear violation of the law of one price, says Thaler. In principle,
traders should have been able to turn a quick profit by selling the
higher-priced shares and buying the cheaper ones. In practice, the risk
that the mispricing might become more extreme made them cautious. Such
“limits to arbitrage” are relatively common in financial markets, but
aren’t sufficient to justify a complete overhaul of modern finance
theory. If anomalies can be traded profitably, they will be.
Thaler’s claim that behavioural quirks are
systematic and persistent is doubtful. Exponents of market efficiency
maintain that share prices contain all available information and that
their future movements are unpredictable. The Winner’s Curse, on
the other hand, pointed out that stocks are, in fact, mean-reverting:
outperforming shares tend to do less well in the medium term, while
underperformers tend to recoup their losses. In other words, their
future performance is somewhat predictable. The book drew attention to
another finding showing that shares that had historically traded cheaply
relative to their earnings or book value (known as value stocks) tended
to deliver above- average returns.
These observations were actionable and
have been acted on. Today, trillions of dollars are invested in value
and other quantitative “factors”. (Thaler himself is involved in an
investment firm that adopts this approach.) Yet, as shown by the latest
edition of UBS’s Global Investment Returns Yearbook (2026), the
excess returns delivered by factor-based investing have diminished in
recent years as more and more dollars have pursued a limited opportunity
set. This appears to support the “adaptive market hypothesis” of the
MIT economist Andrew Lo, which asserts that market inefficiencies,
behavioural or otherwise, do not persist indefinitely. Value stocks have
delivered their greatest returns when they were abnormally cheap.
Behavioural economists, who assume that human irrationality is
unchanging, overlook this important detail.
Thaler and Imas admit that behavioural
economics has produced no standard overarching general theory. There is
nothing in the new book about macroeconomics because Thaler says he
couldn’t come up with a sharp anomaly in that field. What this means is
that behavioural economics has nothing to say about the most significant
economic questions of the day, such as the collapse of productivity
growth across the developed world, the credit crunch of 2008 or the
recent return of inflation.
Because Thaler confines his research to
individual behavioural quirks, he wasn’t among the few behavioural
economists who anticipated the dangers posed by the technology bubble of
the late 1990s or the credit boom and bust that followed. Shiller, the
author of Irrational Exuberance (2000), which was published as
the tech bubble peaked, has a better record in this respect. But
behavioural economists in general failed to recognize the role that
falling interest rates, in particular, play in stimulating bubbles. They
resemble the doctor who mistakes the sweat on the patient’s brow for
the disease and has no knowledge of the real source of the fever.
In 2008, Thaler and Cass Sunstein published Nudge: Improving decisions about health, wealth, and happiness.
The book set out to show that behavioural insights could be used to
improve public policy outcomes. The aim was to influence people’s
behaviour by changing the context in which decisions are made, the nudge
being defined as “any aspect of choice architecture that alters
people’s behaviour in a predictable way without forbidding any options”.
The book sold millions and attracted the attention of the incoming
British prime minister David Cameron. In 2010, Cameron set up a
Behavioural Insights Team (familiarly known as the Nudge Unit) in the
Cabinet Office. Shortly before entering office, the prime minister had
proclaimed in a TED Talk that “behavioural economics can transform
people’s behaviour in a way that all the bullying and all the
information and badgering from a government cannot possibly achieve”.
Nudges were seen as elegant solutions to human shortcomings; they suited
the prevailing individualistic ethos, were inexpensive to implement and
politically uncontroversial.
It was not surprising that the
“libertarian paternalism” of nudging appealed to the Eton-educated One
Nation Tory. Before becoming an MP, Cameron had served as the head of
communications for the British media company Carlton Television. Many of
the insights of behavioural economics – such as inertia, present bias,
peer pressure, risk aversion and the influence of context on
decision-making – are well known in the world of marketing and public
relations. (Robert Cialdini, the American marketing guru and author of
the bestselling Influence, 1984, attended Nudge Unit seminars, along with Kahneman and Thaler.)....
....MUCH MORE
Previous visits with Chancellor:
September 2020 -
Edward Chancellor: «Prudent Investing is Impossible These Days» We like Edward Chancellor.May 2016
Lessons From the Mississippi Bubble--Edward Chancellor
Whenever emerging markets felt a little too frothy this last decade we'd trot out a bit of Chancellor profundity:
"Emerging market speculation tends to appear at a juncture in the economic cycle when
declining yields on domestic bonds combine with an excess of capital to make
foreign investments particularly attractive."
-Edward Chancellor
Chapter 4, Fool's Gold: The Emerging Markets of the 1820's
And from The Market.ch, September 11:....
July 2022 - Interest Rates: William J. Bernstein Reviews Edward Chancellor's "The Price of Time"
Two very sharp people.
September 2022 - Someone Who Really Understands Interest Rates: Edward Chancellor On "The Price of Time"
January 2024 - Edward Chancellor Reviews Friedrich Hayek
And many more.
Have I mentioned I don't like the nudge people?
Ah, I see I have. More below
Cass Sunstein via the Social Science Research Network:
Misconceptions About Nudges
12 Pages
Posted: 9 Sep 2017
Cass R. Sunstein Harvard Law School; Harvard University - Harvard Kennedy School (HKS)
Date Written: September 6, 2017
Abstract
Some people believe that nudges are an insult to human agency; that
nudges are based on excessive trust in government; that nudges are
covert; that nudges are manipulative; that nudges exploit behavioral
biases; that nudges depend on a belief that human beings are irrational;
and that nudges work only at the margins and cannot accomplish much.
These are misconceptions. Nudges always respect, and often promote,
human agency; because nudges insist on preserving freedom of choice,
they do not put excessive trust in government; nudges are generally
transparent rather than covert or forms of manipulation; many nudges are
educative, and even when they are not, they tend to make life simpler
and more navigable; and some nudges have quite large impacts.
SSRN download page
Previously on Nudge:
June 2017
"The Limits Of Persuasive Realities: Hacking The Brain Stem With VR Marketing Technologies"
I should probably state my biases right up front, I don't much care for the "nudge' people.
August 2013
"Nudge
Squad": White House Creating "Behavioral Insights Team" that Will Look
for Ways to Subtly Influence People's Behavior to Get Us to All Act
"Better"
Nudge Squad.
Sounds like a '70's chimera: Mod Squad meets Esalen Institute.*
September 2015
Updated--Cass
Sunstein: Score! Presidential Executive Order -- "Using Behavioral
Science Insights to Better Serve the American People"
Possibly also of interest:
Nudge This: "The Internet of Things Will Be a Giant Persuasion Machine"
March 2015
Nudge This: "The Algorithmic Self"
The writer,
Frank Pasquale, is a professor of law
at the University of Maryland, and is the author of the forthcoming book
The Black Box Society: The Secret Algorithms That Control Money and Information.
And, on the off chance Bloomberg View's Matt Levine should see this,
38 footnotes!
September 2014
Behavior: We Are More Rational Than Those who Try To 'Nudge' Us
I don't care much for manipulators.
For a time however I tried
to work the word into every conversation. I knew a finance guy who, for
whatever reason, could not say the word, when he tried it came out as
'nipulators.'I loved it when he'd go on a rant about the nipulators and
nipulation, I'd egg him on and just melt when he got going.
Good times.... And most artfully:
October 2022 - Behavioral Economics: "We don’t have a hundred biases, we have the wrong model"
November 2016 All the Cognitive Biases In One Chart Via the Incidental Economist:
