Behavioural economics isn’t dead yet

Just a few years ago, many were proclaiming the decline of behavioural economics. In 2009, the well-known game theorist David Levine delivered a lecture called “Is Behavioural Economics Doomed?,” in which he casts doubt on some prominent behavioural theories. In a few fields, such as finance, behavioural ideas have gone mainstream; in others, like game theory, interest is slowly building. But in most policy-relevant fields it remains marginal. And many believe that macroeconomics, in particular, will remain mostly untouched by behavioural ideas. University of Michigan macroeconomist Christopher House wrote in 2014: Today, it seems like behavioural economics has slowed down somewhat. For whatever reason, the flood of behavioural economists we were anticipating 10 years ago never really materialized and the financial crisis hasn’t led to a huge increase in activity or prestige of behavioural work…Behavioural economics won’t get very far if it ends up being just a pile of “quirks.”
House has a point — human psychology is hideously complex, and the various ways that people depart from rationality don’t tend to fit together into a simple, measurable theory. Ultimately, economists want theories they can test with data. Lab experiments help, but economists need to know how people behave in the real world, and for that they have to rely on economic data, which is often sparse. Highly complex theories are impossible to test with real-world data, which is one reason economists are always looking to simplify. There are good reasons to go with a simple but reliable theory that explains only 20 percent of the evidence instead of a complex, hard-to-test theory that could explain 90 percent but might also be full of mistakes.
Recently, some researchers have been making heroic efforts to simplify behavioural economics, with only partial success. It’s relatively easy to identify how “behavioural” consumers are — that is, how much their actions seem to deviate from full rationality. People who are less rational tend to be in worse financial shape. But the ways in which they’re less rational are myriad, and can’t be reduced to a few simple psychological biases. In other words, mistakes add up, but everyone is making different kinds of mistakes.
This throws cold water on the dream of linking psychology with economics, since it means that seemingly irrational economic behavior results from the sum of a whole plethora of psychological effects. But it’s possible that macroeconomists could still make progress by modeling the behavior itself, without thinking too hard about the psychology that gives rise to it.
Some macroeconomists are now trying to do this. A while ago I wrote about top theorists Xavier Gabaix and Michael Woodford, who are working on models of slightly irrational consumers. They aren’t the only ones. Slowly, behavioural models seem to be infiltrating macro.
One example is a paper by Northwestern University’s Lorenz Kueng. He adds yet another piece of evidence against the so-called permanent income hypothesis — the theory that rational, forward-thinking consumers don’t increase their consumption when they get a temporary boost in income. When the Alaska Permanent Fund — a pot of money funded mostly by oil revenue — gives people their annual handouts, they go out and binge instead of sticking it all in the bank as standard rational theory would predict. Kueng shows that this is consistent with a behavioural theory in which consumers are close to rational, but not quite.
Another example is a paper by Rawley Heimer, Kristian Myrseth and Raphael Schoenle. The authors document how young people save too little, and the elderly spend too little, relative to standard fully rational theories. The latter might be explained by old people wanting to pass money to their children, but low savings among the young require an explanation. Heimer and Schoenle’s theory is that young people don’t realize how long they’re going to live. Far from believing in their own immortality, Heimer et al. posit that young people spend like there’s no tomorrow. Presumably, once they reach middle age, people regret their youthful binges.
A third strain of behavioural macro looks at how people learn about the economy. Whereas standard theory assumes that people know how likely big recessions are, a series of new papers theorize that people learn about those probabilities during their own lifetimes. After the Great Recession, people might have realized that big downturns are much more likely than they ever knew. The sudden evaporation of unjustified optimism could be one reason the recovery was so slow. The really interesting question is whether society forgets earlier episodes, like the Great Depression, dooming the economy to repeat those long slumps again and again.
So the people proclaiming the death of behavioural macroeconomics might have been a bit premature. Even if psychology itself doesn’t answer the big economic questions, we may benefit from new macroeconomic theories that assume people are just a little bit
irrational.
—Bloomberg

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion