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 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.

Shiller on Animal Spirits

Robert Shiller in his address to the RSA notes that the use of the term animal spirits or spiritus animales referring to animating feelings that drive our thoughts and actions has had a 2000 year history. Keynes used this term in the 1930s to portray the motives that lie behind the market and to explain the occurrence of depressions. He used this to argue for macro fiscal stabilisation policy to be used in conjunction with monetary policy in undermining fear that was gripping agents in the economy.

Thirty years later, the efficient markets revolution of the 1960s as espoused by scholars Modigliani and Miller converted many to the perfect markets hypothesis. This theory eventually gained ascendancy to thwart Keynesian macroeconomics and led to Thatcherism and Reaganism in the 1980s. Ultimately, faith in the assumption of perfect information that markets embody may have left markets exposed to extreme cycles of bubbles and busts, shocks which gradually have eroded confidence in the theory itself.

He speaks of his long association with George Akerlof the former president of the American Economics Association spanning over twenty years in developing behavioural macroeconomics and with Richard Thaler in developing behavioural finance. Over fifty years of research since Keynes has contributed to some extensions of animal spirits. The book uses the constructs so often ignored in the economic literature relating to:

• Empathy: a modern term that is distinguished from sympathy, relating to the way we are able to experience something that is happening to someone else, e.g. we feel left out, sad during an expansionary bubble if we are not invested in the market and are not profiting from it unlike those around us,
• Fairness: people are very alert to being slighted, i.e. sticky wage theory which is based on rigidities found in labour markets arises because people react negatively towards wage reductions,
• Corruption/bad faith: comes as a result of a lowering of standards (due to greed for example) i.e. the sub-prime mortgage meltdown has led to distrust towards the banks and legal contracts in general and leads to an unwillingness to transact,
• Money illusion: the way individuals react to inflation and deflation is based on the illusory effects of the value of money,
• Stories: social psychology tells us that the mind is organised around stories or narratives; people relate to stories rather than dry statistics.

Overall, these insights tell us that people are proximately rational. It is only under stressful conditions when undertaking decisions of significant emotional content that the animal spirits take over the rational mind. A memorable moment came when he quoted Larry Summers, chief economic advisor to Pres Obama who said that on the crucial policy issues of the day, none were being informed by economists.

In responding to the possible collapse of the banking system, governments in Britain and the US acted swiftly in order to cut off the oxygen from the narratives that were building to prevent stories that were proliferating of individuals affected by the possible bank collapses. Their accurate reading of the stiuation did not come from an understanding of behavioural economics but from their survival instincts.

When a member of the audience challenged his view that the crisis was driven not by these “panic” attacks but by the accumulation of reserves in China that supplied cheap money to US housing markets, Shiller pointed out that China’s massive savings rate developed over time. It came as a result firstly of the One Child Policy which was the Communist Politburo’s response to the narrative built up in the ‘70s by Club of Rome about the “limits to growth”; and secondly, by the story woven today of China’s resurgence in the global scene. The result of this has been the sense of nationalism and self-sacrifice that is justifying this need for savings. Fascinating stuff!

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.

A Stimulating Debate

Back in November, this space predicted that rising unemployment would become the source of headaches this year (given the declining skilled vacancies index, which incidentally have not bottomed out). At that point, it was not yet apparent whether the crisis in the financial sector would seep in to the real economy (translation: whether the fall in stock prices would translate into slowing growth and higher unemployment).

Some have argued that despite the medicine administered by the Reserve Bank of Australia and the Government in the second half of 2008, the rate rises during the first half of the previous year (when the rates in the US were headed the opposite direction) had alterred the public's perceptions of future prospects in a profound way.

These pundits argue that due to their "rational expectations" nothing that monetary or fiscal policy does now can "fool" them out of their present consumer funk. Here's one example from a former Clinton administration insider, who has turned anti-Obama stimulus advocate, Dick Morris.

The size of borrowing programs around the globe will most likely lead to higher interest rates in about three to four years. The sad thing about this is, when that time comes, the global economy might still be in a precarious state. Under that scenario, governments will be faced with three unsavory options: cut spending, maintain spending (through deficits), or raise taxes. Even if the global economy revives within this time, some serious crowding out will take place.

Considering the better than normal status of Australia in the developed world (we had a public surplus previously amounting to 2% of GDP in 2007), the arithmetic presently being applied has to do wtih maintaining a deficit to GDP ratio of less than 2-3% (a sustainable level) while keeping the economy out of recession. This is still possible in the current financial year (given the IMF projections), but looks increasingly difficult in the next. This is why the government is presently banking on its stimulus to spur spending and investment.

Wealth or income?

One important facet of the debate both here and America revolves around the size and timing of tax rebates to working families. Does a once-off large rebate stimulate the economy more than smaller, regular ones? Those that argue for one big lump sum believe that size and urgency does matter. Critics of it say that since it is not lasting, that much of this once-off payment would be tucked away and not circulated in the economy.

Behavioural economist Richard Thaler's work provides some guidance. In the mind of recipients, the question is settled, and it depends on the sort of “mental accounting” they perform. As lucidly explained here in the New Yorker by James Surowiecki, if the stimulus gets recognised as a form of wealth endowment, it will more likely be siphoned off as savings. If it is seen as additional income, recipients will have a greater propensity to spend the regular amounts.