LONDON (Reuters Breakingviews) - What do you get when you merge psychology with economics? Richard Thaler, who just won the Nobel Memorial Prize in the latter field, has an answer, which he calls behavioural economics. The University of Chicago professor’s approach to the study of the mind is more dismal than cheerful. He made his reputation pointing out some of the ways that people do not think straight.
Psychology, though, is a far more than a catalogue of human confusions. The economic benefits of psychological research are far greater than most of today’s behavioural economists seem to realise.
Take the standard economic model of how corporate bosses choose their investments. They are supposed to invest if – and only if – the expected return on a project is higher than the weighted average cost of the capital required to finance it. In fact, the future is far too opaque for the needed estimates to be more than educated guesses. Indeed, the model-makers don’t even bother to keep up with changes in the real world. As Breakingviews’ Swaha Pattanaik pointed out (here), the typical estimated cost of capital has not declined along with nominal and real interest rates.
The models are accurate to within a 10th of 1 percent, but the results almost always confirm the intuition of the boss. That insight comes from applying some not always well understood rules of thumb to the limited data that is actually available.
Academic psychology can help with those rules of thumb, which it studies as heuristics. In many professions, machines can replicate and even improve on human intuition. Automatons can integrate more data than people, and can be trained to learn from mistakes. If these expert systems can help doctors give better diagnoses, they can probably help companies make better investments. It’s certainly worth a try.
Or take thinking about statistics. The normal human brain seems to struggle to find good heuristics for the science of probabilities and statistical significance. Scientists are often no more naturally statistical than lay people. It took decades to persuade doctors to prefer studies of statistically significant sample groups to anecdotal experience.
A firmer grasp on the psychology of learning could help avoid awesomely bad statistical heuristics, such as that shown by David Viniar as the financial crisis started a decade ago. The chief financial officer of Goldman Sachs said the bank’s traders had suffered “25-standard deviation moves, several days in a row”. In lay terms, he was saying that they suffered from incredible bad luck. That is a terrible explanation. Such a level of misfortune would be as likely to occur by chance as often as winning the big prize in the UK’s National Lottery 42 days in a row.
The typical economist is probably better than average in understanding what statistics can and cannot explain. A remarkable proportion of current research in the field is dedicated to using sophisticated statistical techniques to find hidden patterns in vast amounts of data. Still, deeper study of how to think about statistics could help economists think more clearly, and avoid the all-too-common mistake of confusing correlation with causality.
Better statistical intuition might also help economists analyse trade-offs, such as between higher costs and less pollution. Ultimately, though, such debates require the use of a different part of the mind: the ethical or moral faculty. Economists generally claim to be ethically neutral, but without a clear method to debate what makes an economy or a society truly good, they typically fall back on ethically sloppy goals such as maximising efficiency or output.
When psychologists talk about morality, they are essentially philosophers. Economists would gain from joining them. The millennia of philosophical debate about the nature of the good life and the good society may not have reached any definitive conclusions. But studying the works of Plato and John Stuart Mill makes Thaler’s criticisms of the classic economists’ ideal of rational actors maximising their utility seem pretty trivial.
A truly informed psychological economics would elevate current debates. Take the furore over inequality. With better heuristics, researchers could give policymakers a clearer idea of the likely effects of changes in taxes, pay structures and migration policy. With better statistical reasoning, more people could understand the significance of measures of, say, income differentials and intergenerational social mobility.
And with deeper moral thinking, questions of justice, which are hardly broached in the current inequality debate, could be addressed more intelligently. The difference between equality of opportunity and of outcome deserves more attention, as does the possible obligation of residents in rich countries to help narrow the gap with poor countries. Branko Milanovic, a researcher at the Graduate Center of the City University of New York, has shown that this cross-border gap creates far more global income inequality than is found inside rich lands.
Behavioural economics is a fairly modest step in the right direction for a profession that is too often isolated from other currents of modern thought. A true psychological economics, with a touch of philosophy, would be a much larger improvement.
Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.
Sign up for a free trial of our full service at https://www.breakingviews.com/trial and follow us on Twitter @Breakingviews and at www.breakingviews.com. All opinions expressed are those of the authors.