Saturday, November 1, 2008

First Thoughts on Behavioral Economics

Another fascinating and insightful article by David Brooks. I recommend the whole thing - you can read it here.

His thesis:

....there are four steps to every decision. First, you perceive a situation. Then you think of possible courses of action. Then you calculate which course is in your best interest. Then you take the action.

Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest. But during this financial crisis, that way of thinking has failed spectacularly.

So perhaps this will be the moment when we alter our view of decision-making. Perhaps this will be the moment when we shift our focus from step three, rational calculation, to step one, perception.

His conclusions: are not perfectly efficient, people are not always good guardians of their own self-interest and there might be limited circumstances when government could usefully slant the decision-making architecture.... But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they’re even more likely to filter inconvenient facts.

Brooks seems to be leaving us with a very valid yet very intractable dilemma. I read him as saying that our capitalist system needs a very small amount of outside intervention in limited circumstances to ensure the national welfare. However, the government - the only institution with any meaningful resources at its disposal that is dedicated to the public good - is woefully unlikely to perform the needed actions effectively.

So what do we do (assuming that he is on to something here)?

I don't know. A couple of thoughts though:

1. Brooks mentions in the article that the emerging field of behavioral economics may be able to provide some insightful theories and frameworks that could improve our economic policies and institutions. I have limited experience in this field to date, but based on what I have studied, I think he is right - and the possibilities are quite exciting.

2. If we are going to resolve this issue as a society, we are going to have to abandon much of the political and economic dogma that has defined much of the last 50 years. I suspect that this exact same essay - if written by a self-described liberal like Paul Krugman instead of the respected conservative Brooks - would be immediately dismissed as an argument for bigger government and a more centralized (i.e. socialist) economy.

This is not what Brooks is saying at all. He is merely acknowledging that there is probably a set of very specific circumstances in which the government should intervene and provide guidance on the economy. He is not advocating an alternative to capitalism and free markets - quite the opposite - he is discussing measures to make them function more effectively and ensure their long-term viability.

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