Economics finally opens to reality?

Probably. Richard H. Thaler, a leading figure in the field of behavioural economics emphasizing the limitations of rationality, was the recipient of the Nobel Memorial Prize in Economics in 2017, 15 years after Daniel Kahnemann was awarded, who is also a pioneer of behavioural revolution.

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Behavioural economists have repeatedly demonstrated by examples from our everyday life and experiments that our decisions do have limited rationality. Why does every model use the ‘homo economicus’ (economically modelled, rational agents) concept? Mainly, in order to simplify. Since the middle of the XXth century, mainstream economics – inspired by the achievements in physics – have been trying to formalize and describe human behaviour and the economy by equations. I still have the vivid memory that macroeconomics lectures (the branch of economics the behaviour of the economy as a whole) were nothing but the professor writing equations on the board for ninety minutes. Sometimes, he had even started it before the lecture so that we had a chance finishing it.

There is a saying ‘It doesn’t matter how fast you’re going if you’re headed in the wrong direction’. Why is there a need for the condition of rationality? If we are not rational, then how could our decision be modelled? If we give different answers to the same question depending on how it was phrased (something that behavioural economists have told us countless times), how could consistent models be based on it? They could not, or only with extreme difficulty.

Of course, economists reading this could say that I am not right because people are often rational about their decisions, especially if the stakes are high, so their models can be used/are applicable. Economic policy too was (and still is) dominated by this attitude in the past decades. This moved deregulation and the faith in market regulation. This thought guided Alan Greenspan, one of the most impactful central bankers of our time, whom the world awed for two decades for the achievements of the American economy so that in 2008, the financial crisis could pinpoint the limitations of market operator’s rationality.

This debate is of great importance for money markets; it is not a coincidence that Thaler’s research mainly focused on this field. Firstly, investment decisions can be extremely risky; secondly, they result in measurable outcomes. According to Thaler, the capital market reflects that its operators are often irrational, so he does not agree with the advocates of market efficiency.

Why are there manias and collapses short-term alternating each other? They cannot be explained by the change in foundations. Why do investors care so much about the short-term fluctuations of markets if they invest for the long-term, for example for their retired years? Why do low-priced shares perform better in the long-term (in other words, why does values-based investing strategy work)?  Why is there a momentum in the markets (or why is the short-term performance of the recent best shares better, and why do all these things become the complete opposite in the middle-term?)

Thaler does not only warn us about the errors in people’s decision-making but also offers answers and solutions to them. In his book Nudge, the main message is that people can improve their decisions by the adequate calibration of questions and answer options. For example, when people are faced with a situation where they have to choose, they tend to stick to those the questioner offered, if there are any. This way, choosing the one which is the most rational in the long-term as a standard, so in case the person wants to change it, he or she has to put effort and extra work (like filling out additional contracts) into it.

Thaler says that one of the most crucial matters people are not rational about is the question of long-term savings (retirement planning). The majority of people cannot resist the short-term joy of spending money in the present, while they do not care about their future self like it did not exist. As an answer, he created his ‘Save More Tomorrow’ programme, which is becoming widespread in America. Essentially, it says that though we know we should save more, we cannot give up spending in the present. For this reason, we should commit that any time we get a pay-rise in the future, a great portion of it should automatically be transferred to our pension fund instead of our bank account.

Another way to solve the problem that young people have little savings is that if we take our portrait and by using a software, age ourselves by 20-30 years and put it on our desk. Suddenly it is so much easier to imagine that we are going to retire one day.

Rajk László College for Advanced Studies, with brilliant timing (wish we had the same luck all the time!), invited Mr Thaler a month ago, to receive the College’s Neumann Award. Everyone was welcome to listen to his presentation at the Academy. Thanks to the Rajk László College, I had the luck to take part in a dinner with Mr Thaler and a few other people, where he shared the following experience with me:

During the 1980s in New York, when he was already interested in the relationship between behavioural economics and investing, he came across an investment firm called Concorde that asked for advice because they wanted to work on investment strategies based on behavioural economics principles. Thaler had kept in touch with this company, which eventually closed down but it still had its long-term office rental agreement. Acquiring it, Thaler initiated his own – still successfully operating – asset management, Fuller & Thaler.

Original date of Hungarian publication:  October 17, 2017