The award of the 2017 Nobel to Richard Thaler confirms the economics discipline is in a healthy intellectual renaissance. He and many others in the field are moving beyond long-dominant assumptions that now are more fetters than tools. This work is healthy for the discipline and fruitful for society as a whole. So I welcome the award.
The choice particularly pleases me because Thaler is a pragmatic economist concerned less with the beauty of some abstract theory and more with how new insights affect daily activities of people — truly a “real world economist.” As a practitioner of what we call “behavioral economics,” Thaler challenges the notion that markets function partly because people, by default, act rationally.
Citing real-world examples, such as in investing and saving for retirement, Thaler sees that people often act irrationally, and not in their own best interest. The question then becomes, how do societies react to this for the best possible outcomes for the most people?
But while Thaler has helped destroy some existing foundational assumptions, he is not a vandal or iconoclast, as some are, into theoretic destruction as an end in itself. He identifies areas in which historic assumptions and activities are not only in error, but treacherous. Yet he is also happy to identify situations in which existing analytic tools still can be useful, even if accepted wisdom at the time of their forging is now proven to be wrong.
To understand what we mean, let’s go back to the emergence of economics as a separate academic discipline with the 1776 publication of Adam Smith’s The Wealth of Nations. Smith’s key insight — one of the most important of the last millennium — was that human societies spontaneously generate systems to create and transmit incentives so that resources such as raw materials and good ideas can be transformed into goods and services to meet people’s needs and wants. Contrary to the prevailing thought of Smith’s day, if we need onions, kids’ underpants or a pipe wrench, we don’t need some action by government for that need to be satisfied; “markets,” and the incentives they offer, often do the work.
Smith’s tome was impassioned, articulate and rich in anecdotal evidence. It worked a revolution in thought about business and government. But it was very raw and incomplete. Other “classical” economists including David Ricardo and John Stuart Mill broadened and deepened this. And, in the last half of the 1800s, others formalized expression of the discipline with the graphs and algebra that still plague new students.
Every good idea gets taken to excess. Smith’s basic idea that “markets” could allocate resources and products, without government action, became, for some, a belief that market forces, left alone, always produced the best possible outcomes. Any government “interference” whatsoever would make society worse off. This “scientific truth” just happened to mesh neatly with the economic interests and political views of society’s well-to-do in the last half of the 1800s. And traces of it persist into contemporary politics.
Continuing scholarship, however, identified situations in which such idyllic market outcomes were hampered. If there was monopoly power or external costs such a pollution, or “public goods,” or imperfect information, or barriers to entry, then it need not be true that government action would make society worse off. Economics subfields grew up around each such source of “market failure.”
There was, however, little questioning of the most fundamental assumption of the market model — that people are rational in all important economic decisionmaking. That remained pervasive from Ricardo until late 20th century. Indeed, theories based on assumptions of hyper-rationality called “rational expectations” and the “efficient market hypothesis” came to the fore in macroecon theory and finance respectively in the 1970s and 1980s. These are still powerful ideas.
However, the whole edifice of rationality had been based on a 150-year-old simplifying assumption, not on empirical research by psychologists. As psychology matured in the 20th century, the gap between how economists assumed people made decisions and what research revealed about how they actually did this became glaring. This gave rise to behavioral economics, an intellectual movement in which Thaler has played an important part.
He is not alone by any means. Israeli psychologist Daniel Kahneman, who won a Nobel back in 2002, and his colleague Amos Tversky, did important empirical work. And there were many others. But Thaler is someone who has done exemplary work on both abstract and applied issues.
In this two-century-plus long process of evaluating the market model developed by Smith, Ricardo and others, there always is a choice for those who find defects. Do you reject the whole idea as false? Or do you search for ways to repair defects so that markets can still be the foundation for economies?
Karl Marx rejected markets. But most economists recognized that the inherent strengths of market-based economies were vital. So they searched for ways to ameliorate the defects.
Too much monopoly power? Regulate railroad and utility rates or break up large companies. Insufficient resources for education and research? Set up public schools, land grant universities, an agricultural extension service, the National Institutes of Health and the Defense Advanced Research Projects Agency. Inadequate transportation infrastructure? Dredge, dam and lock major rivers and build thousands of miles of highways. Too many scams by Wall Street operators? Set up a Securities and Exchange Commission to enforce basic rules for the financial sector.
The pendulum has swung back and forth, with some economists seeing government taking too large a role and some seeing that role being too small. But there is a broad consensus among economists and most ordinary people that the “mixed market economy,” based primarily on market forces and private institutions with some government action to correct for market failures, is the best, even if imperfect , way of organizing an economy. Arguments about the details notwithstanding.
Thaler follows in this vein. People often are not rational and policies and institutions based on that assumption may be treacherous. But is there some way to correct for this fault within the basic institutions we have? Are there predictable patterns to people’s irrationality that can be exploited?
For example, people undersave for retirement. If left to their own decisions, we either would have indigent geezers or people living on the public dole. Forced saving via social insurance programs like Social Security is one approach. But can we also do things to tweek private savings? What if we make the default for voluntary savings plans like 401(k)s be that new employees are automatically enrolled unless they opt out, rather than that they be enrolled only if they opt in? Conventional econ would predict that participation rates would be the same either way. But they actually are higher if the default is opt-out rather than opt-in.
Much digestible information is available on the Nobel web site, in its news release and official citation for Thaler. His 2008 book “Nudge: Improving Decisions about Health, Wealth, and Happiness”, co-written with law professor Cass Sundstein, gives more real-world applications. But the crux of the matter is that Thaler is a productive, insightful and articulate scholar whose work is improving the real world. This was a good choice.