Humans Misbehave, Economists Misunderstand, Governments Overreact

Carsten Rehder/picture-alliance/dpa/AP Images
Carsten Rehder/picture-alliance/dpa/AP Images

We don’t think like economists.

Now, that’s certainly not news to you–unless, of course, you’re an economist. In his new book, Misbehaving, Richard Thaler gives an amusing tour through his career as an economist and describes his ongoing attempts to convince fellow academics that they don’t think like normal people.

“The problem is with the model being used by economists, a model that replaces homo sapiens with a fictional creature called homo economicus, which I like to call an Econ for short,” Thaler writes.

Since humans don’t behave the way models say we should, those economic models make a lot of bad predictions. “Virtually no economists saw the financial crisis of 2007-08 coming,” he admits (although another behavioral economist, Robert Shiller, did warn about soaring housing prices). “Worse, many thought that both the crash and its aftermath were things that simply could not happen.”

Thaler sets out to change the way economists approach their profession.

“The core premise of economic theory is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one it could afford. Furthermore, the beliefs upon which Econs make choices are assumed to be unbiased,” Thaler writes.

Of course, that theory doesn’t survive a meeting with reality.

Nobody should smoke–the long-term costs (lung cancer, COPD) and sin taxes on the product (Cigarettes cost more than $10 a pack in New York and would set back a heavy smoker by $100,000 over 20 years.) mean an economist would never take up the habit. Yet millions do light up.

As another real-world example, Thaler notes that until recently, economists generally started with the assumption that people would save “the correct amount” for retirement. But that’s asking people to make decisions with information they can’t possibly have.

How could they know when they’ll retire? What the stock market is going to do between now and then? How long they’ll live after retirement? Whether they’ll be healthy? Whether the cost of living will change where they retire to?

And that’s just a quick list of variables off the top of my head that it would be literally impossible for a 40-year-old to anticipate.

So Thaler aims for a humbler brand of economics, one that recognizes reality and encourages people (He’s co-author of the book Nudge) to act more sensibly–more like an Econ, if you prefer.

He calls it “mental accounting,” and it means finding out how people really think about and react to financial situations.

Look no further than the recent stir over Sen. Marco Rubio’s finances. The New York Times was worked up because when the presidential candidate earned $800,000 for a book advance, he spent $80,000 of the windfall on a boat. But that’s not unusual behavior for a normal human. (An Econ would, no doubt, invest the entire $800,000 in a fund that pays 10 percent compounded annual returns, if he could find one this side of Bernie Madoff).

“Consider Jane, who makes $80,000 per year,” Thaler writes. “She gets a $5,000 year-end bonus that she had not expected. How does Jane process this event? Does she calculate the change in her lifetime wealth, which is barely noticeable? No, she is more likely to think, ‘Wow, an extra $5,000.’ People think about life in terms of changes, not levels,” Thaler writes.

Moreover, “It is changes that make us miserable.” No gains, of course. Anyone would love an extra $5,000, or $800,000. Don’t look a gift horse in the mouth and all that. But in his research, Thaler found that people fear loss more than they crave gains, and that changes how most people approach everything.

Of course, even Thaler sometimes makes assumptions the way an Econ would.

At one point, he offered a class of executives a choice: “Suppose you were offered an investment opportunity for your division that will yield one of two payoffs.  After the investment is made, there is a 50 percent chance it will make a profit of $2 million, and a 50 percent chance it will lose $1 million.” Only three of the 23 said they would make the investment; even the CEO said he would have wanted all of them (for an expected gain of $11.5 million).

In the real world, though, nobody could predict gains–or the odds of making gains. Maybe your project will make $1 million, or lose $3 million. Or there’s a 33.3 percent chance it’ll fail. Everyone goes into every project assuming it’ll succeed. (Or else, why bother?) But it’s pointless to offer people choices based on information they couldn’t have going into a decision.

In the end, Thaler notes, nudges can be good or bad. “People can be nudged to save for retirement, get more exercise, and to pay their taxes on time, but they can also be nudged to take out a second mortgage on their home and use the money for a spending binge,” Thaler concludes.

That also means that we should beware of “experts.”

The same people who promised Obamacare would save you money are eager to run your lives in myriad other ways. As Prof. Angelo Codevilla notes in an important essay at The American Spectator:

Americans use land inefficiently in suburbs and exurbs, making it necessary to use energy to transport them to jobs and shopping. Americans drive big cars, eat lots of meat as well as other unhealthy things, and go to the doctor whenever they feel like it. Americans think it justice to spend the money they earn to satisfy their private desires even though the ruling class knows that justice lies in improving the community and the planet.

The ruling class knows that Americans must learn to live more densely and close to work, that they must drive smaller cars and change their lives to use less energy, that their dietary habits must improve, that they must accept limits in how much medical care they get, that they must divert more of their money to support people, cultural enterprises, and plans for the planet that the ruling class deems worthier. So, ever-greater taxes and intrusive regulations are the main wrenches by which the American people can be improved.

It’s an important warning.

The answer to economic puzzles isn’t to give governments more power, or to give more power to economists who’ve shown they can’t make accurate predictions. The answer is to empower people through free markets. Enable people to make their own choices and, over the long run, they’ll succeed.

Of course, we’re on the wrong track with Obamacare, climate change, Common Core, regulation through the FDA, EPA, DoE, and on and on and on.

The real lesson is that it isn’t people who’re misbehaving; it’s big government that pretends it can effectively run our lives. I look forward to reading that book.