The entrepreneurial state: more shoving, less nudging

What is the role of the state?

Since conservative ideology gained ascendancy in the 1980s, most people tend to regard the state as a sluggish, unwieldy and overbearing beast which often gets in the way of private enterprise and creativity by imposing higher taxes and burdensome regulation. 

Those advocating for a minimalist role for the state say that the growth of debt has caused the crisis in the EU, which makes the need for austerity paramount in rebuilding its fortunes.

Mariana Mazzucato, professor of economics at Sussex University has recently published a book called the Entrepreneurial State. The title will sound like an oxymoron especially to those steeped in the tradition of Adam Smith’s Invisible Hand and David Ricardo’s theory of Comparative Advantage in which the market not the state holds primary importance in the economic life of a nation.

Under this rubric of market ideology, the role of the state is to get out of the way of business. State investments are frowned on for “crowding out” private investment. Any type of intervention in the free market only leads to distortions that prevent capital from flowing to those sectors which deserve them the most. 

Today even the task of countercyclical spending when business and consumer sentiment collapses espoused by the Keynesian school of economics is challenged by pro-austerity advocates who question the effectiveness of stimulus measures.

The only place where the importance of the state is acknowledged in promoting growth and industrial diversification is in the developing and emerging world. But even there, the role of the state has been confined to that of a ‘facilitator’: nudging businesses along, addressing ‘market failures’, reducing transactions costs like corruption, providing basic infrastructure, the protection of property rights and the rule of law.

In the advanced economies of the West, where the state is relatively corruption free, where market institutions are mature and where economies operate on the edge of the technological frontier, there does not seem to be any role for the state except in providing tax credits for innovation, improving human capital and supplying basic research and development.

In popular culture, prestige is given to the entrepreneurial class, those rugged individuals who take risks, great visionaries that have given birth to new industries. The stories of Google, Apple and Microsoft are seen as shining examples of this. These are popular myths that Mazzucato’s book seeks to dispel.

Through programs funded by obscure agencies like DARPA, ARPA-E, the National Science Foundation, the National Institute of Health and the Small Business Investment Company, the US government developed the technological building blocks with which these companies built their innovative products. Far from being a bastion of the "market friendly model", the American state has in fact conducted industrial policy by stealth, according to the book. 

Far from being risk averse, these state actors showed the capacity to take risks, support nascent industries, took the role of “patient finance” as opposed to private venture capitalists who came in late in the piece and piggy backed on the wave of technology that the state generated. 

But instead of supporting the entrepreneurial state, what many iconic companies that have benefited the most from it have done is seek to diminish it by availing of tax loopholes.

This leads to another key theme of the book: the socialisation of risk and privatisation of reward deepens inequity in society. A certain amount of wealth creation and concentration is a natural consequence of disruptive innovation which gives rise to massive profits or rents. 

Although the state did much of the heavy lifting in producing general technologies which became the basis for such wealth, it is unable to reap a share of the rewards from it.

There are a number of policy implications presented by Mazzucato including the need for new risk-reward models in public private partnerships. She proposes income contingent loans as a possible alternative, allowing the state to be rewarded when the start-ups it funds become profitable. 

A model that would allow the state to recover its losses from some bad investments by making a killing from a few good ones sounds sensible.

The growing number of sovereign wealth funds in advanced, emerging and developing economies presents an opportunity for entrepreneurial states to fund the next round of innovation. For advanced economies, this would allow them to get out of the productivity rut that has been noticed since the 1990s. 

For emerging economies, it allows them to avoid the middle income trap by moving up the value chain. For developing countries, it would help them “catch-up” in the technological race.

Far from being an inhibitor of growth, the state according to Mazzucato provides the impetus for it:

And this is the punchline: when organized effectively, the State's hand is firm but not heavy, providing the vision and the dynamic push (as well as some 'nudges'- though nudges don't get you the IT revolution of the past, nor the green revolution today) to make things happen that otherwise would not have...This requires understanding the State as neither a 'meddler'nor a simple 'facilitator' of economic growth. It is a key partner of the private sector - and often a more daring one, willing to take the risks that business won't.

Chief Nudging Officer of Obama administration resigns

The frontpage of the Washington Post reported that Cass Sunstein a co-author of the influential book Nudge and advisor on regulatory reforms resigned from the Obama White House. responsible for streamlining existing regulatory policies and procedures while acting as gatekeeper to new ones, Sunstein is said to have left for personal as well as professional reasons.

Instead of Tax Cuts, Nudges to Join Community Groups?

In Baseline Scenario, James Kwak neatly discusses the implications of the science of happiness and that of behavioral economics on public policy.

It is an intriguing read, as he observes that the two seem to point us towards opposite directions. While behavioral economics tends to provide a basis for the state to get involved intimately with people's lives (i.e. finances, diet, fitness, sexual activities, vices, child-rearing to name but a few), the science of happiness supports the notion that besides guaranteeing a minimum standard of living, the state should take a back seat to churches and other forms of socio-civic engagements. That is because additional income above a minimum threshold does not increase happiness as much as human contact (among other things).

So rather than handing out tax cuts (that increase our incomes but do not necessarily improve our level of happiness), should the state be providing what behavioral economist Richard Thaler calls "nudges" to encourage greater social connections?

That would give both liberals and conservatives something to be both happy and sad about.

Nudge Theory Makes Its Way Across the Pond

First it was the Obama White House that adopted nudge theory by appointing Cass Sunstein as regulatory czar, examining all new regulatory proposals. Now it is the coalition government of PM Cameron which has provided a home for it in 10 Downing Street with the setting up of a nudge unit as reported by Andy McSmith of the Independent UK.

The fact that this new theory which is sometimes referred to as libertarian paternalism by its founders appeals to both conservative and liberal leaders alike is evidence that it in fact serves as the real Third Way. It is paternalistic in the sense that it supports the idea that people may not necessarily act in their own self-interest at times, an insight revealed by behavioral science. 

But on the other hand the manner by which to correct this according to the theory is not by imposing a "one-size-fits-all" solution that often limits choice. Instead nudge theorists look at ways to improve the "choice architecture" or to frame the decisions for individuals in such a way that they come to make better informed decisions.

Cognizant that nudges are present all around us, and that they can be used for good as well as for ill, the idea behind applying nudge theory is to correct bad nudges that might lead to predatory practices that abuse the rights of consumers or to improve the poorly designed nudges with respect to personal individual decisions that could have profound public and social impacts such as the amount of savings to set aside for retirement or the kind of health insurance to purchase.

These nudges are cheaper for society in the long-run and lead to greater personal and societal happiness as well, which is probably why the leaders of both the US and the UK are both seeking to apply them, given the tight fiscal situations they are facing which require major reforms in the coming years.

Nudge or Shove? Debating the Merits of Behavioral Economics in Policymaking

In designing policies that reduce negative externalities or public "bads" (as opposed to public "goods") such as the ills associated with the rise of obesity or carbon pollution, governments have borrowed many instruments from the behavioral economist tool kit.

The recent health care measures in the US that mandate the printing of caloric content of food in menus and packages is one example; so is the use of peer pressure in the billing systems of regulated energy companies that use informational cues (smiley faces) to instruct customers of their relative efficient use of power (compared to that of other customers).

These approaches try to influence irrational decision-making by some without necessarily limiting the choices of those for whom they are intended and without imposing unnecessary costs on others whose decisions are perfectly sound and rational. A more direct and appropriate approach to resolve these problems according to Lowenstein and Ubel in a recent NY Times piece entitled Economics Behaving Badly would be to increase the relative cost of consumption whether of fatty processed foods  by withdrawing subsidies to their key ingredients like corn oil or that of energy by putting a price on carbon.

The two pillars of the behavioural economist school argue that policymakers have taken the politically expedient route of utilising the light touch or "nudges" espoused by their field when the more direct but unpopular approach of applying subsidies and taxes prescribed by traditional economists or "shoves" would guarantee the desired outcomes more effectively.

Not so, counter Sunstein and Thaler, authors of the influential book Nudge: Improving Decisions About Health, Wealth, and Happiness. Both traditional and behavioural approaches are needed to influence decisions by rational and irrational actors. The fault they say lies in the politics of the situation, not the economics of it.

The Development Trap

In his weekly column Cielito Habito has been following the jobless growth phenomenon that plagues a number of developing states like the Philippines. This was evident in the first quarter figures for 2010 which showed that just as the economy expanded by 7.3%, unemployment rose by 300 thousand. The country's growth did not translate into a lower unemployment rate. Habito rhetorically poses the question

Where did the impressive first-quarter growth come from? (...M)oslty from petroleum refining, electronics and processed food (...P)etroleum refining is (...) an industry not particularly known to be job-rich (...) Electronics (...) is an industry with almost zero linkages elsewhere in the economy. 

(...) The message is clear: We need economic growth that widely involves and benefits more industries, more geographical areas and more sectors of society—not the narrow, shallow and hollow growth ... in recent years (emphasis added).

This paints the picture of a dual economy where growth and opportunity are restricted to a few enclaves to the exclusion of the vast majority of participants. In recent years, the Philippine macro economy has been on solid footing. Just as some beleaguered European nations were applying for IMF assistance, the Philippines was exiting from its supervision after a thorough process of market liberalization, privatization and deregulation.

Having finally weened itself off the assistance of the DC-based institution, the country can now begin to chart its own development path without the policy impositions of the Washington Consensus. One silver lining  from the recent North Atlantic crisis according to Robert Wade is the opportunity to re-examine strategies for promoting industrial development, a recognition that other paths, for instance the BeST consensus (from Beijing, Seoul and Tokyo), are equally if not more viable. He explains that

(o)n the face of it, raising the state's capacity to coordinate a selected set of economic agents is a more feasible task than across-the-board formalization and enforcement of the rules - a task which requires high fixed costs and many decades, and which often provokes fierce resistance, especially from those already in the elite.

(...) Concrete manifestations of this kind of institutionalized coordination include Japan's MITI, Taiwan's Economic Planning Council and its Industrial Development Bureau, South Korea's Economic Planning Board, Singapore's Economic Development Board; and also numerous industry associations.

In contrast to "developmental state" forged by its East Asian neighbors, the Philippine state in its post-independence, pre-martial law incarnation was corrupted from the bottom-up as

the big landed families (...) used personalized rules of the game to obtain political protection in order to oppose industrial transformation, and used corruption to protect their existing sources of rents.

(...D)emocratization has somewhat restrained a state which under Marcos plundered from the top down, and has moved the nation a little way in the direction of a joint state-business project of a developmental state.

A typical developmental state would not score highly against the World Bank governance indicators based on the experience of East Asia. This is because in a bid to foster more inclusionary growth, state officials may have to actively steer the value stream of investors who might otherwise not source from local firms. This might require gentle nudging and incentives to begin with to strong arm tactics to get their message across as in the case of Taiwan, where

(t)he Industrial Development Bureau (IDB) officials in charge of ... specialised glass considered that at least two Taiwan glass makers could meet the price and quality of the glass imported by the Philips TV factory if given a long-term supply contract and some technical help.

(...) Philips (...) refused to consider the idea, saying it was happy with its existing arrangement to import from a Philips factory elsewhere. But then Philips began to experience delays in authorization to import the glass, which previously had been granted without delay. Philips protested. The delays lengthened. The IDB officials reminded Philips of the advantages of switching to domestic suppliers ... eventually Philips got the message, entered into a long-term supply contract with a domestic producer and in so doing built up goodwill in the IDB.

This example demonstrates that while generous tax concessions and free trade areas might foster foreign direct investments in specific industry sectors, they do not inevitably lead to greater industrial diversification. Pro-active and sometimes robust engagement with industry is required in order to accomplish that.

Among the organizational features of a developmental state observed by Wade are the targeted improvement of state agencies in charge of industrial policy, the fostering of a public service mindset among its officials, the bifurcation of political patronage channels and economic bureaucracy so that the former do not affect the latter and an industrial extension service with tight limits on the use of discretionary resources.

With the weak fiscal position awaiting the incoming government of Benigno Aquino, the immediate task of shoring up the budget situation is imperative. But in order to simultaneously pursue his vision of good governance and the rule of law, a more targeted approach than would otherwise be recommended by the good governance (GG) adherents of the Washington Consensus is required. One which would make more judicious use of limited public resources in building up state capacity towards more inclusive development.

A Nudge State, Nanny State or No State?

The public service has often been portrayed as either ineffectual or overbearing. It either produces nothing of value or worse it extracts from the dynamism of markets. With the advent of a new theory of the state, could things be about to change?

It was David Brooks who proclaimed the rise of the “Behavioral Revolution” back in October 2008. He was speaking of the way regulatory frameworks are now taking account of imperfect rationality in much the same way that they took account of imperfect competition and imperfect information as part of the natural progression of relaxing assumptions about "efficient markets". The purpose of such regulatory reform is to protect consumers from schemes that exploit their lack of rationality or self-control.

The structure of any decision-making process is neatly depicted here. Imperfect rationality means that faulty perceptions lead to false risk assessments lead to poor decisions by rational actors. These perceptual biases as described by Kahneman and Tversky provide the rationale for "nudges" or even "shoves" by the state to guide the most vulnerable in society to make good decisions without imposing harm on the rest.

The term coined by Colin Camerer for this philosophy was asymmetric paternalism or libertarian paternalism as adapted by Thaler and Sunstein. Cognitive psychology and neuroscience is helping to confirm the dominance of human emotions in swamping reason under certain conditions. Consider a decision you have made in the past involving any one of the following:

• Credit and savings
• Houses and cars
• Education
• Careers
• Marriage
• Addictions
• Child bearing
• Health

Any one of these decisions involves a certain amount of emotional content. The infrequency of these decisions makes it improbable that individuals benefit from personal learning. And they have long lasting even intergenerational consequences. Social learning from family and friends as well as public education campaigns may help. But to the degree that people are subject to confirmation or self-serving bias (where we seek out information that confirms our position), forgetfullness, and a high correlation across groups, we witness their decisions having a cumulative or even contagion-like effect on financial markets, public health, industrial competitiveness and so on.

For those of us who provide analysis and advice in the public service or as part of political staff (whom we in the public service jokingly call the "dark side"), this means rethinking the way we design policies in the coming years. The dichotomy is no longer between letting free markets work or imposing big goverment interventions. It means that the profession of public policy so often derided for not producing enough value or distorting its creation now has a way of enhancing value for the benefit of both markets and society.

Prepare to be nudged

Improvements to the “magic of the market” formula for maximising societal welfare involve intelligent “choice architecture” to address human frailties

According to Franklin Foer and Noam Scheiber, a new theory of state is in its embryos. In a piece for The New Republic they state that

Obama has set out to synthesize the New Democratic faith in the utility of markets with the Old Democratic emphasis on reducing inequality. (Nudge-ocracy: Barack Obama's new theory of the state, May 06, 2009)

They trace the genealogy of this new theory from the 70s with the disilllusionment of the “Old Democrat” establishment figure Charles Schultze with the command and control apparatus of the New Deal/New Society to the reinvention of government and pro-market stances of the “New Democrats” led by David Osborne and Bob Rubin to the current one unfolding. They say

…there is…certainly a sensibility that reigns in Obamaland. Perhaps the easiest place to see it is in the administration's fondness for behavioral economics, the branch of the dismal science that recognizes that humans aren't utility-maximizing utomatons, but flawed creatures who often screw up simple calculations and struggle with self-control. The key behavioral insight is that the way we frame choices matters enormously.

Much of this ethos finds its inspiration from Nudge, a book by his former colleagues at the University of Chicago Richard Thaler and Cass Sunstein (the latter was appointed to head up a regulatory review directorate in the influential Office of Management and Budget).

Foer and Sheiber dissect key decisions of the first 100 days of Obama in office over policies ranging from the banking and housing rescue plans to healthcare, education and the environment in which a preference for market mechanisms to state intervention has been evident to the chagrin of Old Democrats who prefer robust intervention. This is a brief synthesis:

1. where Keynesians like Paul Krugman would have preferred nationalising the banks, Tim Geithner and Larry Summers offered incentives and “nudges” to entice public private partnering to help determine the price of toxic assets,


2. where forcibly rewriting home loan contracts would have been more direct, subsidies were offered to creditors to provide easier terms to borrowers most at risk of default,


3. where the unions preferred beefing up public health and education systems, public options involving competition from private providers were enshrined as a way forward,


4. where environmentalists would have preferred picking winners, a cap and trade system was espoused.

The intent of these policies is not to do away with market mechanisms, but rather to correct for human frailties by offering incentives a.k.a. “nudges” to prompt individuals in the right direction. Foer and Scheiber state that

(i)n the grand scheme of things, these "nudges" were minor tweaks designed to elicit more rational behavior … Not all of Obama's nudges fall out of behavioral economics, per se. Some involve changing incentives to encourage certain activities and discourage others. Some involve fostering competition to trigger innovation. But, as in the behavioral examples, the Obamanauts typically have an outcome they want to promote. And, like the behaviorists, they instinctively recoil from imposing it unilaterally. So, instead, they monkey around with the choices people face, seeking to influence decision-making rather than mandate decisions.

A Con at BrisCon

If you were faced with two investment opportunities:

• one involving the purchase of a stock at 1/1000^th of the asking price, and
  
• the other involving the purchase of a stock with a possible future obligation to pay 2000 times the original unit value of your investment, which one would you take?

Obviously, the first one would be almost irresistible; the second would seem quite dubious to anyone. It came as a shock to many mom and pop investors that, in the case of their BrisConnections holdings, the two options were identical. As reported in the Sydney Morning Herald this week,

BrisConnections stapled units were sold in a initial public offering last July, with investors paying the first of three $1 instalments at the time.

They were then required to pay two further instalments, one this month and another in January 2010.

But many shareholders sold out of the stock after it was listed, with the units closing at 41 cents on the first day of trading.

They had plunged to 0.1 cent by October and have remained around that level ever since.

Many retail investors bought the units thinking they were getting a bargain, without realising that they would be required to pay a further $2 on each unit, making themselves liable for further payments up to 2000 times the value of their investment.

To borrow the words of Richard Thaler and Cass Sunstein, authors of the book Nudge, this is a case of poor “choice architecture”. One of the main points found in the book is that although many of us would like to think of ourselves as rational decision-makers, we are often primed to make foolish choices by of the way solutions are framed.

As behavioural economists point out we are (aside from being rational beings) subject to human frailties that our reasoning often gets confounded by complexity. What a layperson perceives as a perfectly reasonable choice upon closer scrutiny often turns out to be misinformed. Discounting this very nature of our thought processes may lead to a poor design of “nudges” or the prompts that are aligned to the way our brains are wired preventing us from perceiving a situation correctly.

In the case of BrisConnections, investors thought they were buying into a project which had a compelling business case with an implicit state guarantee at a huge discount. They failed to assess the risk of contingent liabilities. Yes there were public disclosures but most do not read the fine print when accepting an offer is only a mouse click away. Following Nudge principles, a simple prompt after the person has pressed “accept” warning them of the possible value of their contingent obligations would have alerted many to the dangers of proceeding.

Smart Intervention

With the conclusion of the American electoral cycle conducted amidst one of the most severe economic storms the globe has seen since the Great Depression, many are suggesting that the repudiation of the GOP at the polls in both the presidential and congressional races means that the era of bigger government intervention is back.

It was a combination of imprudent deregulation of financial markets on the one hand coupled with unwarranted government intervention in the housing market on the other that led to the collapse of such Wall Street icons as Lehman Brothers placing great clouds of uncertainty over the major economies of the world.

The most tired bit of analysis floating around with the ascension of the Democrats in Washington is that a new dawn has come heralding the end of economic fundamentalism (a term used by Warren Buffet), the neoliberal agenda with the ‘magic of the markets’ at its core. The economic philosophy espoused by Reagan and Thatcher has been the cornerstone of fiscal and economic policies of both Conservative and New Democrat/New Labor governments over the last thirty odd years. It is time to dust up John Maynard Keynes and consign Milton Friedman back into storage, so they say.

Joseph Stiglitz, a Nobel Prize recipient in economics for his work on the 'economics of information', former Chief Economist of the World Bank and former Chairman of the Council of Economic Advisors under Pres. Bill Clinton, has rightly pointed to the laxity of financial regulation in credit and derivatives markets under the Bush White House, coupled with monetary easing by the Federal Reserve in response to the post-911 and dot com collapse in the early part of the decade as foundations for the present sub-prime mortgage crisis.

This is only half the picture, which deflects a fair share of the blame that should be laid at the feet of the Democrats. The other half comes from the unintended consequences of well-meaning government policies in the housing market ratcheted up significantly by the Clinton administration but initiated as far back in Carter’s to promote greater home ownership by mandating the Federally-supported Fannie Mae and Freddie Mac to allocate a greater share of their lending to lower income groups, the so-called ninjas (no income, no job, and no assets).

The home mortgage meltdown was made up of two failures: a false-negative on the one hand (government failing to act when it should have) and a false-positive on the other (government acting when it should not have). This was a calamity caused not for a lack of public intervention, but by the inappropriate (non-)use of it.


Of course, in the heat of the campaign, a smart candidate like Barack Obama who has reportedly read his fellow University of Chicago professors’, Thaler and Sunstein’s book, Nudge (Yale, April 2008- see left) on this very issue (just as British Opposition Leader, David Cameron has) probably believes that government’s role is not necessarily to mandate things to individuals, but to ensure that they are primed to make intelligent choices, knew that to pose such a nuanced stance would only be self-defeating.

Yet, in his advocacy of tort reform as well as in his healthcare policy which had been opposed by constituents of his own party, trial lawyers in the case of the former, and rival Hillary Clinton in the case of the latter (for being too libertarian) he demonstrated the essence of what is being termed the ‘real third way’, paternal libertarianism: not quite the Keynesian model; one might think of it as the Chicago School of Law and Economics. This new school of thought is in essence a heterodox economic paradigm sprouting from the discoveries made in the budding fields of behavioral and neural economics.

By conducting experiments and studying the mental processes involved in decision-making, this new branch of economics has demonstrated how even highly rational individuals make foolish moves when facing complex, unfamiliar terrain. It demonstrates how our minds often get tricked by the manner in which problems are presented to us.

In order to optimize social benefits in these circumstances, it is not sufficient for policies to merely maximize choice by increasing competition through deregulation. Governments also need to ensure that choices made by consumers are more likely to serve their interests by creating regular feedback mechanisms with which they can evaluate their choices vis-à-vis other options in a timely fashion. This would counteract the inertia of sticking to a current yet less beneficial position or being swayed unnecessarily by the mentality of the herd into making a foolish one.

When laid out in plain English, as Obama did by calling it a policy based on common sense, he contrasted it with the prevailing dogma of neoliberalism. This presented a perfect counterfoil to the seeming blind adherence of the incumbent party to unbridled free markets as a way to allocate resources optimally in society. This soothed the wounded psyche suffered by the American electorate under the current adverse economic climate and appealed to their characteristic sense of pragmatism.

In contrast to the prognostics of most analysts appearing in the news media, the new dispensation is not necessarily going to mean greater intervention by the collective in the sphere of the individual, but smarter intervention. These sorts of intervention do not set out to limit choice, but are designed with better “choice architecture” in which options can be posed in a manner that intelligently spots and corrects for natural, irrational biases present in most humans (read: homo sapiens, not homo economicus).

Of course it remains to be seen whether this new principle can be put into practice by the incoming administration amid the euphoria and stratospheric expectations raised by ambivalent promises made during the campaign, but the kernel of a new idea has been planted, and given time its diffusion is going to be inevitable.