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Economics: Which Way for Obama?

What is going on here? As a matter of logic, we know perfectly well that there is no connection between our cell phone numbers and the date of Attila’s campaigns, but the figure we write down gets stuck in our heads, where it acts as an “anchor” when we come to answer the subsequent question. “In the language of this book, anchors serve as nudges,” Thaler and Sunstein write. “We can influence the figure you will choose in a particular situation by ever-so-subtly suggesting a starting point for your thought process.” Of course, others can do the same thing. Thaler and Sunstein cite charitable organizations that ask, in their circulars, for a donation of “$100, and $150, $1,000, $5,000.” The fundraisers know that few people will give $5,000, but by presenting this set of options rather than, say, “$50, $75, $100, and $150,” they manipulate people into giving relatively large amounts. “In many domains,” Thaler and Sunstein write, “the evidence shows that, within reason, the more you ask for, the more you tend to get. Lawyers who sue cigarette companies often win astronomical amounts, in part because they have successfully induced juries to anchor on multimillion-dollar figures.”

Anchoring is one of several mental shortcuts that Tversky, who died in 1996, and Kahneman, who is an emeritus professor at Princeton, wrote about in a 1974 paper that marked the beginning of what became behavioral economics. (For this and other contributions, Kahneman received the 2002 Nobel Prize in economics.) Another way of saving mental energy, which Kahneman and Tversky termed the “availability heuristic,” involves assessing risks on the basis of particularly salient examples rather than a calm assessment of mathematical probabilities. Fear of a terrorist attack is a good example. Following September 11, 2001, many people, myself included, greatly overestimated the chances of their being killed in another al-Qaeda attack, relative to, say, their perishing in a car crash. A third shortcut, known as the “representativeness heuristic,” involves seeing patterns where none exist. If I flip a coin and get six heads in a row, I may well conclude that there is something wrong with the coin. Much more likely, the coin is perfectly fair and the run of heads was simply a random event.

Once Tversky and Kahneman got people thinking critically about the rational actor model, they and others quickly identified many more mental quirks, or biases, that are pretty much ubiquitous. From the perspective of behavioral economics, the key ones are inertia, overconfidence, and loss aversion. In their everyday existences, people tend to stick with what they are doing, even if trying something different wouldn’t be very taxing. One reason Oprah Winfrey’s television show is so commercially valuable is that so many of its viewers stay with the same channel for the evening news and for prime-time programming. Students sit in the same chair for lecture after lecture. Families go on vacation to the same spot every year. In the vernacular of behavioral economics, they have a “status quo bias.”

At the start of one of his classes, Thaler makes his students fill out an anonymous survey in which he asks them how they expect to perform relative to their classmates. Typically, fewer than one in twenty say they expect to achieve a grade below the median. That is overconfidence. Loss aversion refers to the fact that once people own something they hate giving it up, be it a house, a car, or even a humble coffee mug. Many years ago, Kahneman and two collaborators divided a class of students in two, giving the members of one group a mug each that they could keep. After waiting awhile, the researchers asked the mug owners how much they would be willing to sell their mugs for, and they asked the students without mugs how much they would pay for one. “The results show that those with mugs demand roughly twice as much to give up their mugs as others are willing to pay to get one,” Thaler and Sunstein write. “Thousands of mugs have been used in dozens of replications of this experiment, but the results are nearly always the same. Once I have a mug, I don’t want to give it up.”

Exploring the limits of human reason is interesting in its own right—witness the popularity of Ariely’s book—but what has it got to do with Obama? Thaler and Sunstein lay out a number of principles that can be used to encourage better choice-making, and they apply them to various topical issues, including retirement saving, health care, and the environment. In a number of cases, the measures that Thaler and Sunstein recommend are mirrored by proposals in Obama’s voluminous policy papers, which can be downloaded from his Web site.

In a chapter entitled “Save More Tomorrow,” Thaler and Sunstein endorse the idea of automatically enrolling people in corporate savings plans, such as 401(k)s, rather than making them fill out a form if they wish to opt in. In the idealized world of neoclassical economics, this shouldn’t make much difference—rational people will decide what works best for them and do it. In reality, because of the status quo bias, or, perhaps, because of sheer laziness, the fallback option matters plenty. Studies show that when employees have to sign up, participation rates are often as low as 50 or 60 percent. When people are enrolled as a matter of course, with an option to opt out, the participation rises to more than 90 percent.

For decades now, economists have been bemoaning the fact that so many Americans save hardly at all. Simply offering tax breaks for saving has been tried many times, and it doesn’t have much impact on overall savings rates. Here is a simple, noncontroversial measure that seems to work. An Obama administration would build upon it by requiring firms that don’t offer 401(k) plans to open a direct deposit retirement account for their workers, with an opt-out clause rather than an opt-in clause. For the first $1,000 in savings that an employee contributed, the government would provide a $500 tax credit.

Elsewhere, Thaler and Sunstein endorse Justice Louis Brandeis’s injunction that “sunlight is…the best of disinfectants.” In financial markets, especially, prices are often opaque, which gives unscrupulous businesses ample scope for ripping off customers by imposing on them hefty hidden charges, late fees, and the like. Thaler and Sunstein propose that credit card companies, mortgage issuers, and other financial services firms should be forced to disclose all of their charges clearly, in plain language, so that potential customers can comparison shop. Applying the same argument to cell phone plans, the authors write: “The government would not regulate how much issuers charge for services, but it would regulate their disclosure practices.” Adopting similar language, Obama has proposed a Credit Card Bill of Rights, which would require issuers to provide lenders with full and clear information about the terms of their loans, including all charges.

Disclosure not only helps consumers make better choices: it can also shame businesses into curbing their egregious behavior. Thaler and Sunstein cite the Toxic Release Inventory, a piece of legislation from the 1980s that forced companies to disclose to the government what potentially harmful chemicals they had stored or released into the environment. As James Hamilton pointed out in his 2005 book, Regulation Through Revelation, the measure was originally intended simply to provide the Environmental Protection Agency with more information, but once enacted it allowed activists and the press to target the worst offenders. Fearful of attracting bad publicity, many companies changed their policies, and overall emissions fell sharply. In light of this experience, Thaler and Sunstein propose setting up a Greenhouse Gas Inventory, which would require companies and other organizations to publish the total amount of carbon they are releasing into the atmosphere:

In all likelihood, interested groups, including members of the media, would draw attention to the largest emitters. Because the climate change problem is salient, a Greenhouse Gas Inventory might well be expected to have the same beneficial effect as the Toxic Release Inventory. To be sure, an inventory of this kind might not produce massive changes on its own. But such a nudge would not be costly, and it would almost certainly help.

All of this makes for interesting reading, and much of it is sensible. Having written many times about the shortcomings of neoclassical economics, and the political ends to which it has been exploited, I am sympathetic to Thaler and Sunstein’s effort to construct a more realistic economic philosophy, and one partly based on insights borrowed from other disciplines. However, the more I read of Nudge the less convinced I was that its authors, for all the useful and interesting material they present, have succeeded in their larger aim.

Some of my misgivings were editorial. After starting out strongly, the book gradually degenerates into a laundry list of proposals, some of which seem out of place. Reforming the medical laws so that patients can get cheaper insurance coverage in return for forgoing the right to sue their doctors might be a good idea, as might removing the state from the marriage industry and confining it to the legal endorsement of civil unions; but neither suggestion has much of a connection to behavioral economics. Rather than spending an entire chapter on each of these issues, plus another shaky one on school choice, the authors could have spent more time on issues like myopia and procrastination, both of which have stimulated interesting research. The failure to include any discussion of the difficulties people have in making decisions over time is particularly striking. Readers wishing to know more about this issue, or about the evidence showing that people are surprisingly altruistic and cooperative, at least according to the findings of economic experiments, would be better off picking up an old copy of Thaler’s The Winner’s Curse, of 1992. (One consistent finding: in so-called “ultimatum games,” where subjects bargain over a small sum of money, say $10, they tend to reach egalitarian solutions.)

In defense of Thaler and Sunstein, their emphasis is on public policy. Yet the program they outline seems unduly restrictive. Not content to be behavioralists, they are also libertarians, and they endorse something they call “libertarian paternalism.” They write:

Libertarian paternalism is a relatively weak, soft, and nonintrusive type of paternalism because choices are not blocked, fenced off, or significantly burdened. If people want to smoke cigarettes, to eat a lot of candy, to choose an unsuitable health care plan, or to fail to save for retirement, libertarian paternalists will not force them to do otherwise—or even make things hard for them. Still, the approach we recommend does count as paternalistic, because private and public choice architects are not merely trying to track or to implement people’s anticipated choices. Rather, they are self-consciously attempting to move people in directions that will make their lives better. They nudge.

A nudge, as we will use the term, is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level counts as a nudge. Banning junk food does not.

Many of the policies we recommend can and have been implemented by the private sector (with or without a nudge from the government)…. In areas involving health care and retirement plans, we think that employers can give employees some helpful nudges. Private companies that want to make money, and to do good, can even benefit from environmental nudges, helping to reduce air pollution (and the emission of greenhouse gases). But as we shall show, the same points that justify libertarian paternalism on the part of private institutions apply to government as well.

On the penultimate page of the book, they write:

The twentieth century was pervaded by a great deal of artificial talk about the possibility of a “Third Way.” We are hopeful that libertarian paternalism offers a real Third Way—one that can break through some of the least tractable debates in contemporary democracies.

The addition of the word “real” was presumably meant to distinguish Thaler and Sunstein’s ideas from the “Third Way” approach that Bill Clinton, Hillary Clinton, and Tony Blair endorsed back in the 1990s. But just as that well-meaning intellectual construction project, in which the London School of Economics sociologist Anthony Giddens had a prominent part, suffered from soggy intellectual foundations, libertarian paternalism has some fundamental problems, beginning with the fact that it sounds suspiciously like an oxymoron.

Once you concentrate on the reality that people often make poor choices, and that their actions can harm others as well as themselves, the obvious thing to do is restrict their set of choices and prohibit destructive behavior. Thaler and Sunstein, showing off their roots in the Chicago School, rule out this option a priori: “We libertarian paternalists do not favor bans,” they state blankly. During a discussion of environmental regulations, they criticize the Clean Air Acts that banned some sources of air pollution and helped to make the air more breathable in many cities. “The air is much cleaner than it was in 1970,” they concede, “Philosophically, however, such limitations look uncomfortably similar to Soviet-style five-year plans, in which bureaucrats in Washington announce that millions of people have to change their conduct in the next five years.”

If you start out with the preconceptions about free choice of John Stuart Mill or Friedrich Hayek, it is difficult to get very far in the direction of endorsing active government. (This is precisely the problem that the New Liberals of the late nineteenth century, men like L.T. Hobhouse and T.H. Green, faced.) Once again, consider the subprime crisis. At this stage, it is hard to find anybody willing to defend some of the mortgage industry’s practices, such as offering gullible borrowers artificially low teaser rates that shot up after a couple of years. Hard, but not impossible. “Variable rate mortgages, even with teaser rates, are not inherently bad,” Thaler and Sunstein write. “For those who are planning to sell their house or refinance within a few years, these mortgages can be highly attractive.”

Strictly speaking, Thaler and Sunstein are correct. But many of the borrowers who took out loans planning to sell, or refinance at lower rates, within a few years were speculators, and unwittingly they helped to generate the biggest property bubble in American history. Others were simply taken for a ride. Dealing with this bursting of that bubble is going to involve spending a lot of taxpayers’ money, which surely justifies the placing of some limits on future borrowers and lenders. A refusal to accept that individual freedoms sometimes have to be curtailed for the general good is an extreme position even for a neoclassical economist to take, and it is alien to the traditions of the Democratic Party.

As it happens, there is a coherent and well-developed economic philosophy that was explicitly designed to deal with the law of unintended consequences, and it is regulatory Keynesianism of the sort practiced in the United States and Britain from the end of World War II until the 1980s, a period, not coincidentally, in which working people saw their living standard improve at an unprecedented clip. With respect to the national economy, Keynesians worry that unfettered capitalism is subject to ruinous boom-bust cycles, so they advocate management of demand through interest rates or government programs that create jobs. On the micro-level, they believe that some economic activities have harmful effects that the price mechanism fails to capture, so they support taxation and regulation. Behavioral economics, by demonstrating how people often fall victim to confusion, myopia, and trend following, provides another convincing rationale for Keynesian policies, but you wouldn’t realize that from reading Thaler and Sunstein.

Obama, as far as I know, doesn’t refer to himself as a libertarian, but on occasion he appears to be unduly influenced by the need to preserve choice. Rather than mandating universal health coverage, for example, he has promised to set up a new, subsidized, government-operated insurance plan for people who aren’t covered by their employers and who don’t qualify for Medicare. But if a young and healthy person, for whatever reason, didn’t want to buy health coverage, an Obama administration wouldn’t compel that person to do so, despite the strong financial and moral arguments for expanding the risk pool. Just how to compel healthy young people to buy health insurance remains a large question; but it is one that should be addressed.

On other issues, such as trade policy and regulation of the financial industry, Obama has recently adopted a more dirigiste tone than Thaler and Sunstein would care for. More generally, he has talked about confronting entrenched interests and giving a voice to the excluded. Doubtless, he means what he says, and his ability to attract new voters, especially young ones, suggests he could have more success in overcoming the forces of inertia and reaction than the Clintons did in 1993–1994.

But for what policy purposes are the masses to be mobilized? According to Obama’s program, the answers include another middle-class tax cut; more tax credits for education and fuel-efficient cars; a bigger budget for the National Science Foundation; and the establishment of a National Infrastructure Reinvestment Bank, with an annual budget of $6 billion. At best, these proposals would represent a useful start in redressing the inequities and shortcomings produced by twenty-five years of Republican domination. If the next Democratic president wants to leave a truly lasting legacy, he or she will have to do more than nudge the country in a different direction.

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