George Akerlof and Robert Shiller leave one question unanswered: how can the preferences of a regulator be superior to those of the ones being regulated?
By now, phishing is a term that most people who have used credit cards or have shopped online are aware of. Phishing is viewed as a problem of loopholes and poor awareness on the part of consumers. But it is also a fact that law enforcers will always be a step behind the far smarter phishers who find innovative ways to rip off consumers who are not alert.
In Phishing for Phools: The Economics of Manipulation and Deception, George Akerlof and Robert Shiller, two Nobel Prize-winning economists, extend the idea of phishing to almost all domains of consuming experience and show that instead of being a mere aberration, phishing has a ubiquitous presence in most market equilibria.
Over the past 20 years, behavioural economics has produced plenty of evidence to show that free markets can produce adverse outcomes. Ultimately, humans have both rational and less-than-rational preferences that lead to multiple equilibria that have both welfare-enhancing and poor welfare consequences. This is a far cry from the idea that free markets generate good stuff all the time.
This leads to the analytical core of the book: the idea of phishing equilibrium. In any competitive economy, the choice of investment and deciding what line of business to pursue is based on the returns and profits from it. If a particular business offers greater returns, capital and investment will flow to it. If the returns are low, businesses will exit that line quickly.
Now, if preferences of consumers offer money to be made by dubious means—phishing—then certainly there is a market there. For example, if consumers want tasty but unhealthy foods, want to buy financial products that promise higher than average returns and a whole host of tastes in different markets, then a phishing equilibrium is reached quickly. The economic crisis of 2008 had one such ingredient: the large number of complex, but ultimately rotten, securities. Phishing for Phools is replete with examples—cars, houses, credit cards, medicine and bonds—where the normal understanding of market equilibrium that is welfare-enhancing has been systematically violated. There is no doubt an equilibrium, but one that leaves consumers worse off.
Analytically, the germ of the model for a phishing equilibrium can be traced to a much earlier model by Akerlof dating to 1976, the Rat Race equilibrium. In that model of a modern manufacturing economy, a number of workers work at different speeds in an assembly line. There is a trade-off between the speed of a worker and his utility—faster the speed, lower his utility. Much like the adverse outcomes in phishing equilibria in different markets, most workers end up working at speeds faster than the optimum one.
The solution Akerlof offered for the Rat Race equilibrium—a tax on assembly lines—led to all workers working at the same speed. Redistributing the tax among workers does not affect output and is Pareto optimal. That idea—of government intervention—has been greatly amplified in Phishing for Phools. From properly designed social security and regulation of securities to, extremely, placing limits on campaign contributions of firms (pages 153-162) is the logical extension of this idea.
Akerlof and Shiller are not only Nobel Prize-winning economists but are also individuals deeply concerned at the economic landscape of their country, the US. Perhaps that explains their, rather excessive, faith in the ability of regulation of fix something as basic as human economic preferences. If only regulation—or its cruder and far more deleterious version, an interventionist state—could solve the problem, then socialism would offer a way out of the economic shortcomings of our age. That is open to questioning.
Perhaps that is too strong a conclusion and Akerlof and Shiller may say they just want better designed market institutions. But in their book, they have questioned plenty of mainstream economics—from preferences to how markets function to even textbook ideas such as revealed preference—for their preferred solution to be one of mere redesigning. They leave one question unanswered: how can the preferences of a regulator, or even a set of regulators, be superior to those of the ones being regulated?