Behavioral economists aren't as smart as they think By Scott Sumner

I recently did a post criticizing economists who second guess the behavior of others. This new post gives me another opportunity:

Thaler asserts that good economics needs good psychology, instead of its tradition of inventing bad psychology. He makes short work of various defenses of the rational maximizer model, including “if you raise the stakes, people will get it right,” which studies contradict. Some examples of irrationality: Markets cater to consumer biases rather than correct them. Extended warranties generate $27 billion/year in revenues, even though economists and Consumer Reports agree that one should never buy them. Financial intermediation is 9% of GDP, despite the ease (and almost certainly higher returns for most investors from) index funds. A closed-end mutual fund investing in the Caribbean, not including Cuba, had the ticker name CUBA. Long trading significantly below net asset value (itself an irrationality), its name made the shares spike when President Obama announced diplomatic relations with Cuba, and only slowly retreated over the next few months to net asset value. Housing prices have historically averaged 20 times rents. In the 2000’s they ballooned far above that ratio. A bubble, or what? Economists’ theory of labor markets says that workers earn their marginal product. But when workers shift from high-wage firms to low-wage ones, or vice versa, their compensation falls or rises according to the success of their firm. Janitors make far more at Goldman-Sachs than at Wal-Mart. Is that because they are more productive?

That’s your evidence for behavioral economics? Seriously? I can refute three of these right off the top of my head, and I’ve never even done any research in this area. Imagine what a Gary Becker could have done with this list.

1. Suppose people have some sort of loss aversion. Their anger about being ripped off on a product is far higher than their happiness when things go well. Then buying the product warranty will buy some peace of mind. I don’t buy them, but that’s because I’m unusual. I don’t have the normal amount of loss aversion. But for normal people it’s perfectly rational, i.e. consistent with utility maximization.

2. In the 21st century, long-term real (and nominal) interest rates have fallen to a new normal that is lower that in the 20th century, due to lots of factors such as demographics. So asset prices should be higher, relative to rents. Again, perfectly consistent with rationality.

3. Of course janitors for Goldman Sachs are more productive than janitors for Walmart, how could anyone think otherwise? Suppose you are having a big meeting on a billion dollar deal, and your client walks into the bathroom. The toilet is plugged and overflowing. Gross! How does that affect her impression of your company? Indeed even the Goldman Sachs employees themselves care far more about cleanliness (in dollar terms) than Walmart employees. Not because they have better taste, but because they are richer.

These critiques of the rational choice model aren’t just wrong; they are easily refuted with 5 minutes of thought. If that’s the sort of “critique” that has come out of 30 years of behavioral economics, then I’m glad I never went into the field. And again, these refutations are just off the top of my head.

PS. I admit the CUBA one looks fishy, but even there it’s possible that they thought the liberalization would provide the fund with new and lucrative markets to enter (Cuba is huge), and that given the fund had expertise in the Caribbean, they would have an advantage over other existing funds. That doesn’t explain the reversion in price, but prices change for lots of reasons. And I admit my explanation is a stretch, I’m just saying it’s always possible we are missing some angle. Or maybe it was indeed a random error, as they suggested, but with no important implications for anything else.

And what percent of GDP do the behaviorists believe should be in finance? So that one is hard to evaluate. The claim about index funds may be true, but it has no policy implications. Because investment information is partly a public good, if you adjust policy to push people into index funds, there’d be too little market research.

PPS. Sorry if the tone here was too negative, but if your entire career is built around the idea that most people are stupid, and you’re one of the select few to see through their stupidity, then you better be pretty sure that you have your facts right, or else have a thick skin.

HT: Tyler Cowen