New York Times

June 28, 2003

Calculating the Irrational in Economics
By STEPHEN J. DUBNER

When the Federal Reserve Bank of Boston invited the leading
behavioral economists to a Cape Cod golf resort this month to make their
case,
it was plainly a signal moment. "It has the feeling of being summoned by the
king," said Colin F. Camerer, a star behaviorist who teaches at the
California
Institute of Technology. "Sort of like: `I understand you're the finest lute
player in the region. Will you come and play for me?' "

            Until the last few years, behavioral economics - which blends
psychology, economics and, increasingly, neuroscience to argue that emotion
plays a huge role in how people make economic decisions - was an extremely
tight-knit group. It had little influence and few practitioners. One
economist
at the bank's conference recalled an Alaska kayaking trip that Mr. Camerer
took
with another prominent behaviorist a decade ago. "If that kayak had
flipped,"
he said, "half the field would have been eradicated."

            But the field has grown, as has its influence. In 1996, Alan
Greenspan's warning of "irrational exuberance" acknowledged, as the
behaviorists do, that the average investor is hardly the superrational "homo
economicus" that mainstream economists depict. In 2001, the young
behaviorist
Matthew Rabin won the John Bates Clark Medal; last fall, the psychologist
Daniel Kahneman, a forefather of behavioral economics, was awarded the Nobel
in
economic science.

            And so it was that the Boston Fed summoned the behaviorists to
the
Wequassett Inn in Chatham, Mass. The conference was given the quaint title
"How
Humans Behave," as if monetary policymakers had suddenly realized that, lo
and
behold, on the other end of all that policy are actual people. The
collection
of mainstream economists and central bankers would be the highest-level
audience the behaviorists had ever enjoyed, the best chance yet for their
new
thinking to hit the bloodstream.

            From the outset the mood was civil, especially considering that
the
behaviorists are essentially calling for an end to economics as we know it.
(As
one economist grumbled, "What you have to understand is that behavioral
economics is attacking the foundation of what welfare economics is built
on.")
So it was not surprising that some Fed elders seemed wary, as if they were
at a
family reunion and welcoming a distant cousin about whom they had heard only
puzzling rumors. But with the economy stuck in a condition between dismal
and
desperate, the behaviorists' timing could not have been better.

            "All our models and forecasts say we'll see a better second
half,"
Cathy E. Minehan, president of the Boston Fed, said in her opening address.
"But we said that last year. Now don't get me wrong: mathematical models are
wonderful tools. But are there ways this process can be done better? Can we
inform the policymaker from 50,000 feet with wisdom gained on the ground, in
the human brain, or in the way humans make decisions and organize
themselves? I
hope so."

            Ms. Minehan and her colleagues were particularly hoping to learn
why Americans save too little, acquire too much expensive debt and perform
such
achingly self-destructive feats of portfolio management. The behaviorists,
for
their part, were put in a tight spot: eager to prove themselves but leery of
overpromising. "Virtually everyone doing behavioral economics agrees we
should
go slowly in advocating policy change," Mr. Camerer wrote in the paper he
presented. "Our thinking was also not designed to precisely answer questions
about welfare and policy, but this is a good time in the intellectual
history
of the field to say something."

            Eldar Shafir, who teaches psychology and public affairs at
Princeton, began with a behavioral economics primer. It was full of the
anomalies the field is known for, including the popular "6 jam-vs.-24 jam"
experiment. In an upscale grocery story, researchers set up a tasting booth
first with 6 jars of jams, and later with 24 jars. In the first case, 40
percent of the customers stopped to taste and 30 percent bought; in the
second,
60 percent tasted but only 3 percent bought. The point is that too many
options
can flummox a consumer - and if 24 jars of jam pose a problem, imagine what
8,000 mutual funds can do. Standard economics would argue that people are
better off with more options. But behavioral economics argues that people
behave less like mathematical models than like - well, people.

            Among the behaviorists, there is the common sentiment that
economics has been ruined by math. "Neoclassical economists came along in
the
mid-19th century and wanted to mathematize the new science of economics,"
said
George Loewenstein, a professor at Carnegie Mellon University. "They
couldn't
include `the passions,' or emotions, in their models, because they were too
unruly, too complex. But they also thought that the emotions were
unknowable."

            Mr. Loewenstein described how he and his colleagues want to
prove
otherwise - that not only are emotions not unknowable but that when it comes
to
money, they may be more powerful than math. This is why Mr. Loewenstein
studies
how people make financial choices while they are experiencing various
degrees
of sadness, hunger and sexual arousal. This is why Colin Camerer has become
a
student of brain imaging, trying to identify where a subject's brain lights
up
when, for instance, a lowball offer leaves him disgusted.

            But the most radical idea presented at the conference belonged
to
Richard H. Thaler. His paper, written with the legal scholar Cass R.
Sunstein,
was called "Libertarian Paternalism Is Not an Oxymoron." Leonine and
youthful
at 57, Mr. Thaler, who teaches at the University of Chicago, is widely
considered the founder of behavioral economics (and some say, its next Nobel
winner). He is more confident and, accordingly, more prescriptive than his
younger colleagues.

            "Behavioral economics offers powerful tools to achieve policy
goals," he told the conference. "And libertarian paternalism is an
attractive
approach to solving policy problems. What else? I think the only other
alternative is inept neglect."

            Mr. Thaler has concluded that too many people, no matter how
educated or vigilant, are poor planners, inconsistent savers and haphazard
investors. His solution: public and private institutions should gently steer
individuals toward more enlightened choices. That is, they must be saved
from
themselves. Mr. Thaler's most concrete idea is Save More Tomorrow (SMarT), a
savings plan whereby employees pledge a share of their future salary
increases
to a retirement account. In test cases, the plan has proved remarkably
successful.

            "This was not pulled out of thin air," Mr. Thaler said. "It was
done using what I call first-grade psychology. We knew this was going to
work,
no question." Indeed, the SMarT plan takes advantage of behavioral
economics'
basic tenets: "loss aversion" (people fear loss because it causes them far
more
pain than the pleasure they receive from gain; but since the SMarT plan
covers
a future raise, they never feel its loss); "status-quo bias" (since people
are
reluctant to change, the change can be made for them); and "mental
accounting"
(people have a pressing need to direct different streams of money into
different "accounts").

            Mr. Thaler was followed by David I. Laibson, a young Harvard
behaviorist who also endorsed a paternalistic approach. "There are two
enormous
travesties in the financial services industry," Mr. Laibson said. "One,
people
have too much of their own company's stock, and two, mutual-fund management
fees are too high." His solution to the first problem: an automatic asset
reallocation to keep an employee from holding more than 20 percent of his
portfolio in company stock.

            "People could opt out," he said. "If you're crazy enough to do
that, fine, that's your right, but we'd certainly push them down." His
solution
to the second problem: warning labels about management fees, modeled after
the
surgeon general's cigarette warning.

            Mr. Laibson's and Mr. Thaler's proposals were warmly received by
the bankers and mainstream economists. If this is behavioral economics,
what's
not to like? The proposals seemed to be sound and not particularly invasive
solutions to Americans' troubling money habits. All the earlier talk of
sexual-arousal studies and brain imaging may have left them flat; but here
were
some real action items.

            The behaviorists, most of whom are hardcore empiricists, even
felt
comfortable enough to declare their own research wish lists. Dan Ariely of
the
Massachusetts Institute of Technology trolled the room for a good contact at
the Internal Revenue Service (he wants to study the psychology of tax
cheats).
Duncan J. Watts, a sociologist at Columbia University, half-jokingly
requested
access to the phone and e-mail records of all Federal Reserve employees (he
is
looking for good data to better understand how organizations behave).

            The warm reception didn't mean wholesale conversion. When
Jeffrey
C. Fuhrer, the Boston Fed's chief economist, was asked about Mr. Camerer's
desire for a new Economics 101 textbook, one that puts behaviorism at the
center and mathematical modeling on the fringe, he responded: "Yeah, that's
his
`I Have a Dream' speech. I think that's still weeks off."

            Still, Mr. Fuhrer, who organized the conference, was delighted
with
its outcome: "I think we would have been crazy to expect we'd walk out of
this
conference and say, `O.K., we're going to our next meeting, and now we know
what to do because these guys told us.' But having had these conversations,
where people look at economics from a different viewpoint, will we think a
little differently about how we do research and exactly which people we
might
talk to? You bet we will."

            They may have little choice. As Frederick S. Breimyer, chief
economist of the State Street Corporation in Boston, said, "We're looking
outside the box because the box we've been looking inside is empty."

Copyright 2003 The New York Times Company
http://www.nytimes.com/2003/06/28/arts/28BEHA.html









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