Are you an Econ? Don't bet on it!

kw: book reviews, nonfiction, psychology, economics, errors, behavior, behavioral economics, memoirs

John Maynard Keynes developed early theories of economics and markets, and made a distinction that later economists neglected and then forgot. He stated that the actions people take are frequently prompted by "animal spirits", which he defined as "a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." [Keynes, 1936: The General Theory of Employment, Interest, and Money] In other words, people do not always, or even usually, thoroughly calculate or deliberate upon their decisions.

Fast-forward forty years, from 1936 to 1976. Milton Friedman has become the twelfth Nobel laureate in Economic Sciences. Economic theories have been developing, even proliferating. Men (no woman won until 2009) labored for years to wring a new formula out of the growing mass of theory, a few became Nobelists, and the edifice thus built was indeed founded on the analysis of "quantitative benefits…" and so forth. Social scientists other than economists were beginning to protest that the "rational" decisions that were required for economic theory to work could not be realistically made by genuine human beings. Policies were arising that assumed everyone was capable of making near-instantaneous decisions using the very calculations that Nobel Prize-winning economists had labored for years to discover.

Friedman poured oil upon the roiled waters by invoking the "as if" argument, using an expert billiards player as an example. To summarize, an expert, or even pretty good cueman, does not calculate the outcome of a series of Newtonian physics collisions, but plays as if such calculations had been made. But others, who for the time being mostly kept their thoughts to themselves while they sought tenure (!), realized that this implied all of us have Olympic-level skills when we make economic decisions. Don't I wish!

One of these others was Richard H. Thaler, who began to use the term "Econs" to describe the fictitious super-rational beings (who could out-Spock Mr. Spock) upon which economic theory depended. He distinguished Econs from Humans, a term referring to genuine human beings, who are indeed not Vulcans, but have emotions, proclivities, life histories, and only in the most extreme cases act with unvarnished Reason. Econs never err. Humans seldom fail to err. Extracting useful theories from the reliable errors of Humans has been a major element of Dr. Thaler's work, as described in his memoir Misbehaving: The Making of Behavioral Economics.

Dr. Thaler might be a somewhat unusual economist, because he has befriended and worked with a number of psychologists, including Daniel Kahneman, whose book Thinking, Fast and Slow I reviewed a few months ago. Perhaps most economists fear too much exposure to psychology, because Humans are so complex. Yet it is that very complexity that must be studied, for policy that does not take it into account cannot succeed.

The main "policy" way to get people to do something is to tell them. If the matter is important, perhaps sanctions such as fines will be enacted. A simple example might be (Ladies, avert your eyes) putting a sign in the Men's Room, above the urinals: "Please Aim Accurately. Excess Cleaning is Costly". Such a sign is likely to result in even greater need for cleanup. What to do? Economics is the study of incentives as one aspect of motivation. What motivates Human males? Exhortations typically just rile them up. Of course, if there were no Humans, only Econs, no sign would be needed. Econs never miss. Humans seldom miss if they have an enticing target. Some years ago in Holland something new was tried: to etch the image of a fly just above the drain of the urinal. "Excess Cleaning" needs were reduced by 80%. Don't be surprised if you see a "fly" in a public urinal.

The title Misbehaving refers to anomalies that Dr. Thaler has been collecting for decades, anomalies that could not exist or persist if we were all Econs. The fly-target is just the simplest example. Others include violations of the "Efficient Market Hypothesis" (EMH). The most glaring is a case in which 3Com acquired Palm, then years later sought to divest it by a partial sale of stock, to be followed by successive sales until the whole was sold off. Early sales of Palm shares indicated that, if EMH were true, investors considered the residual value of 3Com to be negative, because the value of all Palm stock at that price would exceed the value of the combined company! This is a small example of a bubble. The existence of bubbles, such as the U.S. housing bubble that burst in 2008, is a huge anomaly contrary to EMH. Bubbles imply that things are wrongly priced, and so does all the talk on morning "business segment" shows about whether a "correction" is imminent. Econs never suffer bubbles or corrections. For them, the price is always right. Always. For Econs, the price they are willing to pay or receive for an equity exactly mirrors all the expected future value of the company and its dividends and even closure costs when it comes to an end. Econs are the ultimate Seers!!

Maybe at work you have access to a 401(k) retirement savings plan. Do you contribute? Does your company pay a matching contribution of the first few percent? For years, taking advantage of a 401(k) required filling out some paperwork, selecting a level of participation, and perhaps selecting one or more funds (including company stock and a few mutual funds) to put your money in, for the next 20-40 years. Making changes was not simple. Participation was low.

I guess I am more of an Econ than usual. I jumped at the chance, starting with 6% (which we could barely afford to sock away, but the company matched the first 6%, so it was like getting free money). Each time I got a raise, I added a percent or two, until I maxed it out. But I knew one guy who put in his 6% each year, but took it back out the following year and spent it. He got his free money, but was only accumulating half as much as someone who saved 6% and left it there with its match. I bet he wasn't nearly as well prepared to retire at 66 as I was. Even more puzzling, in those years, even with 3% or even 6% company matching, more than half of my co-workers never started their 401(k).

A dozen or so years ago, Dr. Thaler and others began convincing companies to switch from this opt-in method to an opt-out one. Employees were informed they would be automatically enrolled in a 401(k), with 3% of their earnings and 3% of company matching funds going into some default investment, usually a money market fund or company stock or a mix of both. If they really didn't want it, they had to sign a certain form and send it to the payroll office. Participation rates increased greatly. Then they devised a follow-on program called Save More Tomorrow: Each time an employee received a raise, half of it (or a different proportion that could be chosen) would be added to their participation rate, maybe raising an initial 3% to 4% or 5%, then to 6% after the next raise, and so forth, up to a ceiling such as the maximum allowed amount. Some companies, not wanting to write extra software to couple the payroll system with the retirement system, opted instead to simply add half a percent yearly to each participating employee's savings rate, unless, again, they sent in a form with differing instructions.

If you have access to a plan such as this, and it has resulted in your saving more toward retirement than you used to, you have Dr. Thaler and other "economics renegades" to thank. Reading such an entertaining, informative book, I was quite encouraged that, finally, some economists are looking at us as genuine Humans, who do things because we like to rather than because of some lengthy, Nobel-worthy calculation; who make decisions when we are happy or sad or mad that are often different from what we'd decide in a calmer mood; who wear green today and blue tomorrow and can't decide what color shirt to wear after that, so we ask our spouse, who likes mauve but we hate it so we grab an apricot-and-chartreuse print and wear that. Don't be surprised if the decision which house or car to buy is backed up by no more thought than that print shirt! We are Humans!!