Home / Opinion / From zombies to misbehavers

Incumbents fight hard to keep status quo in place. And when you have devoted your working life to an idea, you fight harder to keep that idea in currency, no matter what newer evidence shows. Richard H. Thaler, professor at Booth School of Business, University of Chicago, in his new book, Misbehaving: The Making of Behavioral Economics, is calling the end of the tyranny of neo-classical economics and has built the theoretical base for a more pragmatic version of the dismal science that is no longer that dreary. Misbehaving is actually a text book in disguise. It attacks the supremacy of the standard economics that is the basis for most economic policy and builds a theoretical framework for behavioural economics—the new strand of economics that understands that human beings are not machines when they take economic decisions, but humans with all our wonderful flaws.

That there is a need to find another way to explain the world became obvious after the financial crisis of 2008. According to economists, this crisis could not happen. They said this with confidence of being from a social science that emerged from a few core principles—just like physics. At the individual level, the core rules say that people optimize their economic decisions and behave rationally—seeing through the fog that framing of choices causes, not suffering from loss aversion and not being over-confident about what they can or cannot do. So the world is not populated by irrational human beings (or Humans) but perfectly logical Spock-like creatures that Thaler titles “Econs". At the economy-wide level, there is equilibrium because price discovery by the ‘invisible hand’ of the market settles at a point that demand equals supply. As Thaler writes it: “Optimization + Equilibrium = Economics".

However, the premise on which this neat model rests is built on laboratory conditions being present in the economy. What works on paper has failed in the real world, and the crash of 2008 is the latest example. If people were rational, then those with low income would have never taken loans they could not afford, and seen through the balloon interest deals in no time at all. If the efficient market hypothesis was right and the price was ‘always right’, then the market zoom and crash of 2008 was not possible. So, should the entire work of neo-classical economics be junked? No, writes Thaler: “We don’t have to stop inventing abstract models that describe the behaviour of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behaviour, and stop basing policy decisions on such flawed analyses."

The battle to get recognition for behavioural economics was fought in academic conferences and in journals. Just getting a paper printed that challenged the status quo was not easy and conference settings where papers challenging established principles were presented, were hostile battle grounds. Documenting one such conference where a combative economist was arguing against the paper being presented, Thaler writes: “I was shocked by his comment…. if we are free to re-label preferences as ‘costs’ at will so that behaviour appears to be consistent with the standard theory, then the theory is both untestable and worthless." Could the resistance to behavioural economics be due to ‘sunk costs’? Economists had spent the better part of their careers working on the ‘rational actor’ model and to let it go would mean starting over.

The persistence of a small band of economists has ensured that behavioural economics has moved from being ‘the freaky’ outlier to getting embedded in some parts of government thinking. And that is true not just of the US or the UK, but also in India. Using choice architecture to help people take better decisions, for example, has been used in India in the National Pension System that does not take away choice but for those who choose not to choose, puts them in a default option—that of a lifecycle fund which reduces the equity allocation as the person ages.

The battle for recognition is almost over; in the next phase, behavioural economics will lead to deep changes in the way we think about policy and market structure. For example, the buyer beware model that is the industry standard today arises from the Econ model. A human model leads us straight to seller beware. I am waiting for that to happen.

End note: Economists don’t eat their cooking and behave like humans, but write papers as if the world is full of Econs. This duality came through for me from the story Thaler tells about how rooms were allocated when the Booth School of Business moved to its new building on the same campus. The worst insult on the campus is to call somebody ‘paternalistic’ or exhibiting a father-like control on decision-making that reduces individual choice; it is even worse than calling somebody Marxist or an anarchist, writes Thaler. But the same free market anti-paternalistic School fell back on paternalism when it came to allocating rooms in the new building. Instead of a ‘market-based’ method, the university chose to leave the design of the process to a professor known for his honesty by the faculty. When it came to them, the Chicago Business School professors junked the market for faith in a person. How wonderfully human.

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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