The Hindu Business Line : Behavioural economics

At a basic level, the sub-prime crisis seems to highlight that human beings are getting more irrational by the day. How else, would one explain, people taking a loan for another house when payment for the first one is proving difficult? Similarly, the mere idea of selling loans to someone who is a ninja (no income, no job or asset) should have raised goose pimples in a banker but such cases were legion. Enter behavioural economics for policymakers.

Some central assumptions of neo-classical economics may have come a cropper. Human beings are rational but more crucially, irrationality has infinite dimensions. Therefore, if irrationality is assumed, there cannot really be a single theory.

Economists did acknowledge the problem behind this assumption but wished irrationality away. It took two psychologists, Daniel Kahnemann (Princeton University) and Amos Tversky (Stanford University) to show how irrationality can be used in economics.

Their Prospect Theory showed how people become risk averse while gaining and risk seekers while loosing led to many related ideas and answered many puzzles (dubbed anomalies) in economics and finance

After initial scepticism, research in Behaviour Economics/ Finance (BE/BF) has come of age. Initially BE was used to understand decision making by individuals and was more focused on microeconomics. Now, it is being applied in macroeconomics. Boston Fed has even set up a Research Centre for Behavioural Economics and Decision-Making “with the hopes of applying its lessons into more effective economic policy.”

BE has tremendous implications for policymakers. Cultural and social values differ across countries implying varied responses to similar incentives. Americans, it is said, have a higher risk appetite than others.

This implies that a financial product designed for a normal American may not be suitable for others with higher risk adversity. Yet, very similar financial products are offered across countries.

Behavioural economics research also suggests that people don’t really understand risk.

Hence, to expect them to differentiate across financial products is not really prudent. The consequences of financial products with faulty designs have been painfully evident in the subprime crisis.

Michael S. Barr, Sendhil Mullainathan and Eldar Shafir suggest that instead of expecting people to know the myriad disclosure norms, teaser rates, etc., they should be given an “opt-out plan”. In this, each borrower would be offered a simple fixed rate mortgage, which will be a default plan.

The borrower can opt out for another plan only “after honest and comprehensible disclosures from brokers or lenders about the risks of the alternative mortgages”.

Those familiar with behavioural economics would know the origins of this plan. The “opt-out plan” was actually applied to increase pension savings in various organisations. Earlier, employees were given the choice and most preferred not to opt for the pension plan.

Using BE, employees were enrolled automatically in pension plans with the option to opt out. The default option had altered, the onus was now on the employee to opt out of the saving plans. Most preferred to stay with the scheme. This led to increase in pension savings in many organisations.

Policymakers and mainstream economies should rigorously adopt insights from this economics stream. We still do not know how individuals differ across countries and country specific research will lead to fresh insights and help design better and more workable policies.

Amol AGrawal Economist, IDBI Gilts Mumbai

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