Listener June 6, 1998.
Keywords: Social Policy;
I would like to recommend Cornell economics professor Richard Thaler’s The Winner’s Curse: Paradoxes and Anomalies of Economic Life, which describes thirteen general anomalies where the standard economic theory of individual behaviour is contradicted by the evidence. Together they present a serious challenge to the “economic rationalism” which is used to justify so much of recent economic policy. But as important as the book is, many general readers will find it difficult, for it requires a modicum of standard economic theory and/or mathematics to follow some of the intricacies of its arguments. If you can tackle this level of abstraction, do read the book. Or give it to that undergraduate economist nephew who is already obnoxiously telling you how to run your life.
The rest of us need to know that economic rationalism is based upon a set of theoretical postulates about how people behave. But we dont behave like this at all. The thirteen anomalies, each based on numerous experiments or observations about actual behaviour, raise alarming questions about the soundness of the underlying model. Consider savings behaviour.
The theory predicts that if two people with identical lifetime earnings profiles, one with $100,000 of pension wealth and the other with none, then the latter would have other wealth (such as shares and bank deposits) to offset the pension deficit. In practice – as attested by numerous studies – it is not true, even when personality differences are allowed for.
It is always possible to invent ad hoc explanation for an anomaly: the economics rationalists do it all the time. Recall how a planet Vulcan was invented to explain why Mercury did not follow the orbit which Newton’s laws predicted. When nobody could find it, Vulcan was said to be hiding behind the sun. Pre-relativistic physics anomalies kept appearing. For each was found an ad hoc explanation, until Einstein explained how Newton’s theory was wrong. The same applies for savings behaviour. There are numerous other event – like people’s housing ownership and their response to expected and unexpected windfalls – which are inconsistent with the standard model. It hardly matters whether human behaviour is illogical or irrational, or whether the postulates of economic rationalism are faulty. The gap between the theory and the empirical evidence is large.
Thaler’s summary of observed human savings behaviour is in the footnote. The fourth point has significant implications for retirement policy: we are not very good at saving unless there is a contractual element. We save by paying off the house mortgage or contribute to an occupational pension or life assurance scheme. The Retirement Commissioner and Reserve Bank berating us will not markedly raise savings, unless we contract into a compulsory savings scheme. Despite our best intentions, putting a little something aside each week for our old age will not generally succeed. On current policies lots of us are going to have miserable old age.
The behavioral logic is that we need compulsory retirement schemes. And we would welcome them. Not the idiotic privatisation proposal we voted against last year, but something like Labour’s 1974 compulsory contributory scheme, which was on top of today’s New Zealand Superannuation, so everyone got a guaranteed minimum retirement income, topped up by their earnings related savings.
Such proposal ideologically outrage economic rationalists. They say everyone ought to behave according to their theory. Those who do not should be punished with an impoverished old age. For despite their claims to be liberals, the economic rationalists are fascists about personal behaviour. Their’s is “behave according to our rules, or we will punish you.”
The group which the evidence suggests most behave like economic theory are economists. We brainwash ourselves, and then impose on the public our own narrow self conception of the human condition. That behaviour is not of ordinary men and women, who may be economically irrational but do wonderfully human things like laugh and cry, show curiosity and awe, love, care, and create beauty.
How We Like to Save: Thaler’s Rules
(1) Live within your means. Do not borrow to increase consumption except during well-defined emergencies (such as unemployment).
(2) During emergencies cut consumption as much as possible.
(3) Keep a rainy day account equal to some fraction of income. Do not raid the account except in emergencies.
(4) Save for retirement in ways that require little self control.
(5) Borrow only on the security of a real asset.
Each rule, which we think prudent, infringes the economic rationalists’ theory. The last explains why we are under-investing in tertiary education. Students regularly tell me they are stopping acquiring knowledge because their debt is too high. Unless they are economics students, it is pointless telling them they pay the debt off out their higher future earnings.
Thaler says he once explained the difference between his account of human behaviour and Robert Barro’s (an eminent economic rationalist), by saying that Barro assumes that people are as smart as he is, while Thaler portrays them as being as dumb as he is. Barro agreed.