Friday, October 22, 2004

We are all behaviorists now

The WSJ had a front page article on Eugene Fama saying that markets behaved irrationally sometimes. Why did this make the front page of the Journal? Because Fama is the godfather of efficient markets.

I had the good fortune to meet Eugene when I was at the University of Chicago, and it's Fama, along with Becker, Murphy, and a tremendous host of others that makes Chicago Ground Zero for free market economics.

A lesser know fact is that Chicago is also home to Richard Thaler, a key figure in (experimental) behavioral economics, who sadly did not win the Nobel Prize a couple of years ago when Sweden decided to nod towards the behaviorists. I had the good fortnue to take a class with Dick and several opportunities to speak with him at length.

Since the WSJ doesn't allow free linking, I'll point to this TCS post that discusses the same article. It excerpts the main paragraph:
For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the underlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the "behaviorist" school of economic thought, contended that markets can veer off course when individuals make stupid decisions.

In May, 116 eminent economists and business executives gathered at the University of Chicago Graduate School of Business for a conference in Mr. Fama's honor. There, Mr. Fama surprised some in the audience. A paper he presented, co-authored with a colleague, made the case that poorly informed investors could theoretically lead the market astray. Stock prices, the paper said, could become "somewhat irrational."

Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known as the "efficient-market hypothesis," it struck some as an unexpected concession. For years, efficient market theories were dominant, but here was a suggestion that the behaviorists' ideas had become mainstream.

"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr. Fama's presentation."
It is true that behaviorists' ideas have become mainstream (at least at Chicago), but this does not mean what people think it means.

Firstly, the truth is that the Chicago School of Economics was always aware of and looking for explanations for market bubbles -- an obvious (in hindsight) demonstration of market irrationality. More obscure phenomena, such as the "equity risk premium" similarly eluded free market explanations. Behavioral experiments shed light on these and so provide answers to key, outstanding economic questions.

Secondly, the truth is that the cognitive biases identified by Thaler et al do not vanish once the decision moves from the market to the committee. Left-wing folks have gravitated towards behavioral economics because they see it as a way to escape the defeatest free-market prescriptions of classical economics. Unfortunately, behavioral economics says that market participants can be irrational because they are human, which is easily extended into committee members can be irrational because they are human. Behavioral economics does not allow for the benevolent central planning that seems to attractive to many.

So what is it good for? According to Thaler and U Chicago law professor, the provocatively titled Libertarian Paternalism.

What a great title.

Libertarian paternalism takes behavioral insights -- such as default choices matter -- and marries that with the fierce individualism at the heart of libertarianism. So, you let people do what they want, but you work hard to make sure that the defaults are right. This has the benefit of making the default choice (and there must always be a default choice) considered instead of random, but you mitigate the danger of the committee getting it wrong by letting people change the choice if they want.

An example of this is Thaler's Save More Tomorrow plan.
Using principles drawn from psychology and behavioral economics, the plan gives workers the option of committing themselves now to increase their savings rate later. Once employees join, they stay in the plan until they opt out.

The SMT plan has four basic components: First, employees are approached about increasing their contribution rates approximately three months before their scheduled pay increase. Second, once they join, their contribution to the plan is increased beginning with the first paycheck after a raise. Third, their contribution rate continues to increase on each scheduled raise until the contribution rate reaches a preset maximum. Fourth, the employee can opt out of the plan at any time.

The first implementation of the SMT plan yielded dramatic results. The average saving rates for SMT plan participants more than tripled, from 3.5 percent to 11.6 percent, over the course of 28 months.
With social pension plans across the world being put under stress, any sensible approach to savings should be considered.


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