Home / Opinion / When Econs need a shrink

As a student of Economics from when I was in grade eight, I’ve heard the famous Adam Smith words, that the invisible hand of the market will sort everything out. We’re not exactly encouraged to think beyond the text in the Indian education system and it took a postgraduate degree in Economics to understand that what I’d read was so far from reality that it put me off the subject for a long while. My understanding of Smith’s famous phrase is this: when sellers and buyers maximize their own benefit freely, the market is in equilibrium or that prices will rise and fall so that demand and supply meet. This individual maximization of “utility" will benefit the whole community. Therefore, free markets mean good for all.

Just for the record: We’ve been mis-told. The full quote from Smith is this: “…he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it." Itals mine. Saying that society is not always worse is not really what we’ve been led to believe by the free market fundamentalists.

I did not know that I had stumbled upon the result of the interpretation of this 18th century phrase when I unravelled a mis-selling episode in the Indian retail finance market 10 years ago. Mutual funds were being churned faster than a lassi in a blender and I unravelled the product on an Excel sheet to find that the structure was ripe for mis-selling. Agents were perfectly within their rights to maximize their utility if the incentive structure encourages them to churn. And I found that it did. Now, a decade and many battles with regulators and policymakers behind me, I understand this: our markets are built on the intellectual premise that was cooked in the Econ labs of the West, which rested to a large extent on that one (mis)quote of Smith, which said that when markets are free, we’ll all be better off. This thought got further hardened into unreal assumptions under which markets will work—for example, people are rational, they do not suffer from any biases and do not react to framing of a choice set. This version of the market resulted in a buyer-beware framework where rational, utility maximizing consumers can fully take responsibility for what they buy when faced with lots of choice.

We only have to look around to see the widespread failure of this interpretation of Smith. Human beings are not rational when making decisions. We give into biases such as loss aversion—we hold on to losing stocks to push away the moment of loss realization. How a choice set is framed affects our decision—an opt-in choice architecture in organ donation causes very low rates of donation, an opt-out takes donation rates to the high 90s. In the financial sector, the neoclassical econ construct of the market got translated into a buyer beware model that rests on a disclosure and financial literacy regulatory regime. Consumers of retail finance will choose the right product when there are plenty of options, firms will make full disclosure, and consumers will be made financially literate.

But disclosure has turned into obfuscation with meaningless legalese. For a person to buy a health insurance cover, she would have to read 300 policy brochures. If each one takes two hours (will take much longer), the time needed to buy a health cover is 75 days, assuming a working day of eight hours. Do that for life insurance, mutual funds, home insurance, bank deposits, loans and all the financial services you need and you get what we have—an economy with low levels of financialization and inclusion. Clearly, buyer beware does not work when there is information asymmetry; when people are human beings with all the imperfections, and not lab cooked economic agents.

Challenging the neoclassical economics version of the world is University of Chicago Booth School of Business professor Richard Thaler, who built on the work done by psychologist Daniel Kahneman, along with an intrepid gang of status quo challengers such as Robert Shiller. In his new book Misbehaving: The Making of Behavioral Economics, Thaler has put out an alternate economic theory, behavioural economics which takes into account people as Humans and not Econs. I believe that if buyer-beware was the result of the neoclassical interpretation of the “invisible handwave", then a seller-beware market will be the logical conclusion to the Behavioural Econ construct. Here is a prediction. Once the wall of unreal assumptions breaks (this was held in place by economists with sizeable “sunk cost" in defending the world of Econs they built with impossible assumptions), there will be a rush towards interpreting what Behavioural Econ means for market constructs. In my opinion, a seller-beware market is the logical conclusion to what this new economic theory proves. Now to wait for the nerds to prove it through their econ models.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com

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