MAKING SENSE OF ECONOMICS: BEYOND THE OTHODOXY

Talk to The New Institute, Hamilton
August 28, 2007

I’ve now been a journalist for 33 years, spending all that time working for the Sydney Herald and virtually all of it as an economic journalist. So I thought what I’d do tonight was tell you a little about my intellectual pilgrimage over that time – how my views about economics have evolved. I should start by telling you that, though I have a lot of economics in my degree, I make no claim to be an economist. What I was when I came to the Herald 33 years ago was a chartered accountant. I used to tell people I was an accountant pretending to be an economist, but these days I prefer to say I’m a journalist who writes about economics. That gives me a little bit of distance from the economists, a bit of independence, making me a kind of interpreter and go-between between the profession and my readers. Not so much a theatre critic as an economists critic.

I have to tell you that, after 33 years, my enthusiasm for the subject matter of economics – figuring out how economies work, determining what motivates people in the economic aspects of their lives – is greater than it’s ever been. The subject fascinates me – I love making new discoveries about economics and then passing them on to my readers. My ideal holiday is to take a box of new books on economics – most of them bought on Amazon – up to the weekender we rent on the central coast and just sit on a banana chair in the backyard devouring them.

But I also have to tell you that, partly as a result of that reading, I’ve had increasing doubts about conventional economics – doubts at the theoretical level and the practical level. Most economists are pretty smug about the success of their discipline. They ignore their appalling record as forecasters and think the profession has a pretty good handle on how the economy works. But I think economics is hugely primitive. In the 230 years since Adam Smith we’ve uncovered a few basic truths about economic behaviour, but what we don’t know far exceeds what we do. That’s why the forecasting is so bad – we’ve got only the roughest idea of how the economy works.

The core of conventional economics is still what’s called the neoclassical model – the idea that price is determined by the interaction of supply and demand. Economic rationalists are people who take this model and, rather than using it as an analytical tool that you pull out of your kitbag when you think it’s the right tool for the job, elevate it to the status of a religion – a fundamentalist religion. And, like all fundamentalist religions, it has features that some people find very attractive: a few simple rules that, provided you have faith, explain the whole world. It gives you the illusion of certainty and an answer to every question. You can apply the model to any economy, any industry, any market – and the fact that you don’t know much about the specific circumstances is no problem. The model’s answers are always simple and universal.

Now, I don’t want to knock the neoclassical model and its religious devotees completely. Market forces are very real and very powerful. You frequently see people changing their behaviour in response to changes in prices. Market forces are often like a balloon – you can try to repress them, only to see them pop up elsewhere in a distorted form. Black markets are the obvious example.

And the great virtue of economic rationalists, at their best, is their opposition to economic privilege: to producers using some form of monopoly power – whether natural, business-made or government-made – to reduce competition and give themselves an easy, profitable life at the expense of their customers. Many, perhaps most, industries and professions try this on to a greater or lesser degree. In the argy-bargy a few years ago over medical indemnity, I was most entertained to watch the fisticuffs between the two professions that just about invented economic privilege: the doctors and the lawyers. I’ve been thinking that, these days, the race is not so much to the swift as to the industry that best uses the media to win public sympathy for the preservation of its economic privilege – particularly as the political parties become more poll-driven and intent on staying in power by giving the public what it says it wants. The economic rationalists have an analysis, known as public choice, which says that just about all government intervention in industry, no matter how well-intentioned, ends up being captured by the industry being regulated and manipulated so as to advantage the producers over the consumers. I’m afraid there’s a large measure of truth to that analysis.

But that’s enough praise of economic rationalists and the neoclassical model. The model seriously oversimplifies real-world markets and economies. It focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains (though the small businesses usually forget to mention that most of the cost savings get passed on to supermarket customers).

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Another significant weakness in conventional economics is its assumption that economic agents (people) always act rationally – that is, with clear-headed self-interest. The relatively new school of behavioural economics, which draws heavily on psychology, has demonstrated that people’s behaviour is often far from rational. People are emotional and often exhibit herd behaviour, particularly in share and property markets. People don’t even act with an understanding of such basic economic concepts as opportunity cost. With such a flawed model of human motivations as its basis, is it any wonder the economists’ model is such a hopeless predictor of economic behaviour?

Now let me say a little about my new book, Gittinomics. In all the interviews I’ve done to publicise it, only one interviewer has come close to saying the obvious: you have to be pretty egotistical to name an -omics after yourself. So what’s so special about my version of economics? All capitalist economics seeks to explain how the capitalist system works. I guess what’s different about my take on the subject is its emphasis on making sure you’re a master of the system, not a victim. Making it work for you, not you for it.

To that end, the first thing to understand is the need to keep economics in perspective and economists in their place. Economists are experts in one important but limited aspect of life: the material. No one knows better than they do how best to maximise our production and consumption of goods and services. When a community follows their advice - as we pretty much have been for the past 25 years - it gets rich.

Trouble is, sensible people don’t maximise the material aspect of life, they optimise it. That is, they balance it against other, non-material objectives. For instance, most economists know little about the question of fairness and, for the most part, they ignore it. Press them and they’ll tell you frankly that it’s outside their area of competence. Likewise, they’re largely oblivious to the social and spiritual aspects of life. Will the policies they advocate damage family life, for instance? Sorry, never given it any thought. Why don’t you consult a social worker or a priest? Why not indeed. Economists’ advice is one-dimensional. When we give that advice primacy and fail to meld it with the advice of experts in other areas, we risk becoming a richer but more socially dysfunctional society.

And what applies at the national political level also applies in our everyday lives. Most of the things capitalism has to offer us are good - provided we don’t overdo them. Trouble is, the system is usually pressing us to overdo them. Take the ready availability of credit. Thanks to financial deregulation and our return to low inflation, interest rates are lower and the banks are anxious to lend. When we use that credit to buy our own home, we’re generally better off. But when we use credit cards or home equity loans to buy consumer goods we can’t afford, we risk becoming victims.

Credit cards don’t remove the need to save for the things we buy. Since debts have to be repaid, they merely allow us to do the saving after we’ve acquired the item rather than before. The trick is that you also have to pay a lot of interest. So when we allow our impatience to get the better of us, we end up devoting much of our income not to buying things but merely to paying interest. And if carrying a lot of debt on top of our mortgage makes us feel continuously weighed down - I owe, I owe, it’s off to work I go - that’s another strike against our being masters not victims. It’s great to live in such a successful capitalist economy, where not all but most of us enjoy a fair degree of comfort. But when we take the advertising too seriously and start deluding ourselves that buying more stuff will make us happy, we risk becoming victims.

Our politicians venerate the ‘aspirational voter’, but when our aspirations run exclusively to the material we’re setting ourselves up for a state of recurring dissatisfaction. To be masters of the system we need to control our aspirations, learning to be more content with what we’ve got and aspiring to be better gardeners, better golfers, better at our jobs, better partners, better parents, better human beings.

The capitalist system has ways of taking money from the poor, but also of doing down the comfortably off. Really? How? By selling the illusion of social status - and it doesn’t come cheap. The middle class spends an enormous amount of money keeping up with the Joneses and trying to demonstrate how well we’re doing by the clothes we wear, the cars we drive, the homes and suburbs we live it, the schools we send our kids to and much else. Almost by definition, the possessions that most impress people are the ones that cost most. There are too many cases where, provided they get their image and market positioning right, firms can defy the laws of demand and supply and sell more of their product by putting up their price.

What makes this game an illusion is that it’s like an arms race. People are always catching up and passing you, requiring you to earn more and spend more to regain your place. But if you’ve got the money, what’s wrong with spending it on big boys’ toys? Nothing - provided keeping your place in the status race doesn’t lead you to money stress, overwork, a feeling of being trapped or neglect of relationships that matter most.

If it does, you’re a victim. And here’s a good test of whether you are: how much do you enjoy your job? If you’re just doing it for the money, and feel constrained by your financial commitments from moving to a lesser paid but more satisfying job . . . well, you don’t need me to tell you you’re not master of your destiny. But your cage is of your own making. How can you escape to a better job or cut back the long hours you’re working? By reducing your financial commitments. How? By controlling your material aspirations and stopping trying to buy status. Is that too tall an order? Then don’t complain about being trapped by the system.

But wouldn’t the capitalist system collapse if we all cut our spending and did less work so we could spend more time enjoying our relationships? No, of course it wouldn’t. The economy would just grow at a slower rate. And that would be a cheap price to pay for lives that were less harried and where our relationships were more rewarding. I guess that’s what Gittinomics is driving at.

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BEHAVIOURAL ECONOMICS AND PUBLIC POLICY

Dinner address, Reserve Bank Roundtable, August 8, 2007

‘Economics has not only become boring but also threatens to become irrelevant.
Therefore I do not feel embarrassed about being unorthodox. In fact, I rather enjoy it!’
Frey (2001)

One of my favourite economist jokes is the one that says an economist is someone
who can’t see something working in practice without wondering whether it also
works in theory. There are two professions that possess an intuitive understanding
of the propositions economists have come to call ‘behavioural economics’. They are
the marketers, and the politicians. So what is behavioural economics? It’s
economists satisfying themselves intellectually that there is a logic — as opposed to
a rationality — to the intuitive behaviour of economic agents. It’s economists
laboriously disabusing themselves of the mistaken beliefs they have acquired about
the way agents behave, as a result of their internalising the assumptions on which
neoclassical economics is built.

Behavioural economics is the scientific study of intuition. It involves accepting the
power of intuition — that people are much more intuitive than rational — and
understanding the reason why this is so, which gets back to the way humans have
evolved and, specifically, the way their brains have evolved. Neuroscience tells us
that the primitive, more instinctive and emotional part of our brain often
overrides — or beats to the punch — the more recent, more logical part of our
brain. This leads to a strange dualism in our minds: we’re often motivated to do
things by considerations the more intellectual part of our brain knows to be unwise.
This dualism explains why we have ‘present selves’ and ‘future selves’ which, in
turn, helps explain the self-control problem humans have — a major topic of study
for behavioural economists — and the misprediction of utility, time-inconsistent
preferences, myopia and procrastination that this involves (Stutzer and Frey 2006). I
guess what I’m saying is that, for a full appreciation of the intellectual power and
fascination of behavioural economics, it helps to take in some neuroeconomics
(Camerer et al. 2005).

Let me also say that I use the term behavioural economics to encompass the closely
related field of research into happiness — or subjective wellbeing, if you prefer a
more scientific-sounding label. Lest you feel that happiness is taking your
newly-acquired tolerance of behavioural economics a bridge too far, let me just
point out that happiness is the subject that brought Professor Frey’s name to
international prominence (Frey and Stutzer 2002), and that when Daniel Kahneman,
the psychologist who won the Nobel prize in economics for his role in founding
behavioural economics, had finished with prospect theory and heuristics, he moved
on to the study of utility and wellbeing (Kahneman et al. 1999).

Conventional, neoclassical economics is widely held to be positive, not normative.
But one of the things you soon realise when you study behavioural economics is
that this is the wrong way round. Behavioural economics is the study of the way the
world actually is, whereas conventional economics is the study of the way the world
should be. That is, we’re not rational, but in many circumstances we’d be better off
if we were. The study of self-control problems involves reaching an understanding
that the seemingly irrational things people do in their search for commitment
devices — such as failing to claim tax rebates in fortnightly 'pay as you earn' tax
instalments so as to maximise the size of their annual tax refund cheque, which the
person is more likely to save — have their own logic; that they represent fallible
agents trying to make themselves more rational. The study of self-control problems
also leads you to the view that there may be a new role for economics in helping to
make the world more rational, by imposing prohibitions on certain disadvantageous
behaviour. In fact, governments already do this extensively — and with widespread
public acceptance. It’s just that no one sees it as having anything to do with
economics, and often economists would be quietly disapproving of such
interventions.

As an economic journalist, I’m supposed to keep my remarks practical, but I do
want to say something theoretical and controversial. I believe that the assumptions
on which the neoclassical model is based pervade the beliefs and policy preferences
of economists far more than most of them realise. Economists generally have a
strong commitment to individualism, freedom of the individual, the benefits of
choice and the value of personal responsibility and, hence, a bias against
government intervention and a desire to keep governments small and taxes low.
This characteristic of neoclassical economics gives it a great affinity with the
libertarian political philosophy, which to me explains why the right wing of
economic rationalism is a lot more heavily populated than the left wing. (Who’s on
the left wing of economic rationalism? Mike Keating, Fred Argy, Bob Gregory and
a few others.)

But my point is this: I believe conventional economics’ commitment to
individualism and suspicion of government intervention rests heavily — more
heavily than most economists realise — on the assumption that economic agents act
rationally. We doubt that governments could ever know better than the individual
how that individual’s income could best be spent. Why? Because we assume the
individual is rational in all things — that she can accurately predict utility, never
does things she comes to regret and never displays time-inconsistent preferences.
When you accept that individuals are far from rational you open up the possibility
that governments may well be better judges of what’s best for the individual. We
assume agents are rugged individualists and are happiest when treated as such,
whereas psychology tells us humans are group animals, whose preferences are
heavily influenced by those around them, who care deeply about what others think
of them, who are anxious to fit in but also conscious of their status within the group
and desirous of raising that status. In other words, I believe that conventional
economics’ exaltation of individual freedom is simply scientifically outdated — a
hangover from the 18th and 19th centuries, when we knew far less about human
behaviour than we do today.

There are two broad approaches economists can adopt towards the lessons of
behavioural economics. One is to use insights from behavioural economics to
reframe essentially unchanged policy prescriptions from conventional economics,
so as to make them more politically palatable. We know, for instance, that people
react differently to essentially the same propositions, depending on how they are
framed. We know that more people would decline consent for a medical operation
with a 10 per cent failure rate than they would an operation with a 90 per cent
success rate. We know from Kahneman’s asymmetric value function, for instance,
that people weight losses more heavily than gains of the same amount. From this,
Richard Thaler (1985) developed four rules for reframing gains and losses:
segregate gains (don’t wrap all the Christmas presents in a single box), combine
losses (because this reduces aggregate pain), offset a small loss with a larger gain
and segregate small gains from large losses.

The second approach we can adopt is to use the lessons of behavioural economics to
change the policies we pursue. I have no objection to the first approach — indeed, I
think it would repay the close attention of econocrats. But I’m more excited by the
second, more radical approach. So let me suggest some very general policy
implications I draw from behavioural economics.

First, I believe that the profession needs to return to its original goal of maximising
aggregate utility rather than maximising consumption possibilities. We now know it
is possible to measure utility — to some extent at least. We also know that revealed
preference is far from foolproof. People are not good at predicting their utility and
they often come to regret their decisions — even to wish someone had stopped them
doing what they did. We know people get locked into behaviours they wish they
could control. Neuroscience makes it easy to see how people’s consumption
decisions can be influenced at a semi-conscious level by advertising that appeals to
their emotions. Among other implications, a switch of emphasis from consumption
back to utility would require economists to abandon their see-no-evil approach to
advertising. Many of the points that follow flow from a recommitment to
maximising utility.

Second, economists need to study consumption. It never ceases to amaze me that
economists can exalt consumption in the way they do and then take so little interest
in it. The happiness literature makes it clear that people find some forms of
consumption more satisfying than others (Seligman 2002; Van Boven and
Gilovich 2003).

Third, economists need to acknowledge the importance people attach to social
status and social comparison. Conventional economics is good at helping the
community maximise its income, but it can do nothing to maximise people’s
relative income. And yet, we know that people are more interested in increasing
their income in relative terms than absolute terms. From a community-wide
perspective, a status race is pointless and wasteful. It’s likely that, as real income
rises over time, a higher proportion of income is devoted to the purchase of
positional goods. Is this why we pursue efficiency? It’s also likely that efforts to
minimise the role of government and limit the growth of taxation have the effect of
allowing people to maximise their spending on positional goods at the expense of
the provision of public goods that would yield them greater utility (Frank 1999).

Fourth, the simple model of labour supply is misleading and needs rethinking. In
practice, economists tend to underplay the one thing the model gets right: that
leisure yields utility. In the unfavourable comparisons of rates of economic growth
and levels of GDP per capita made between America and Europe, there is little
acknowledgement that much of the difference is explained by the Europeans’
preference for leisure over work. On the other hand, the model is quite wrong in
assuming that work yields disutility. The happiness literature makes that clear —
even if it wasn’t obvious. Like you and me, most people derive great utility from
their work most of the time. It follows that much could be done to increase utility by
policies encouraging job enrichment. That is, when your goal is to maximise utility
rather than consumption, you see for the first time that the issue of job
satisfaction — which may be enhanced by such practices as team work or giving
workers greater autonomy — is part of the economist’s brief.

We know, too, that unemployment is a major source of unhappiness in peoples’
lives — or, if you prefer, of disutility (Clark and Oswald 1994; Layard 2003). This
fact creates a conflict between measures to increase efficiency and maximise utility
DINNER ADDRESS 151
that reformers rarely acknowledge. This may be partly because their modelling
assumes full employment, but I believe it’s also thanks to a hidden assumption that
the unemployed are to be envied for all their leisure time.

Fifth, policy makers undervalue the utility people derive from security and
predictability. We give too little weight to the utility workers derive from job
security, for instance. We need to learn that efficiency isn’t everything.
Sixth, self-control problems are ubiquitous, but susceptible to policy remedies.
Some self-control problems may be regarded as minor (television watching, for
instance), but many constitute significant social and economic problems: obesity,
smoking, drinking, drug-taking, gambling, speeding, the overuse of credit and the
inability to save. Economists aren’t as conscious as they should be that government
intervention — and often, outright controls — to assist people conquer their
self-control problems and to protect the community from negative externalities are
widespread, of long standing and uncontroversial. Consider all the regulation
governing the consumption, sale and advertising of alcohol and tobacco. Consider
all the controls — speed limits, seatbelts, random breath-testing — that have
succeeded in reducing the road toll. Consider the way employees are compelled to
save 9 per cent of their wages, and how little opposition that relatively recent
measure encountered. It’s clear to me that the public often wants governments to
impose these external commitment devices on it — and that this attitude makes
considerable sense. The insights of behavioural economics should help economists
to be much more receptive to proposals to use intervention to alleviate self-control
problems, including the newly recognised problem of obesity.

Economics doesn’t have to be boring, stuck in a rut and open to the charge of being
based on out-of-date science. But to make economics more interesting and relevant
to the solution of a wider range of the community’s problems, economists have to
be willing to learn new tricks.


Behavioural Economics and Public Policy

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