The dismal science has grabbed a couch. After failing to find answers with brute computing power, economics is now seeking help from psychology. Known as “behavioral economics,” this controversial combination of psychological insights and economic methods is moving fast into the mainstream. After Years as a fringe idea, it’s being taught at Princeton, studied in Washington and preached at investment seminars from coast to coast. Business is paying close attention, too. Drugmaker Merck uses behavioral psychology to run its pension plans and to plot its bids for sales contracts. At an annual conference previously dedicated to number crunching, Prudential Securities introduced investors to a Harvard psychologist.
Economics routinely shoots up ideas that take off like comets but fizzle like Roman candles. In the 1960s Keynesians thought they could fine-tune taxes and spending to end recessions forever (chart). The ’70s brought the idea that a simple rule governing the money supply could stabilize the economy, while the ’80s disproved the supply-side thesis that lower tax rates could increase tax revenue. Behavioral economics is more modest in its claims. It won’t cure the deficit or strengthen the dollar. But by factoring in egotism, stubbornness and downright foolishness, it is forcing pie-inthe-sky theorists to come to terms with the real world.
The merger of psychology and economics began on the fringes of academia two decades ago. Two Israeli-born psychologists Daniel Kahneman of Princeton and Amos Tversky of Stanford-challenged the notion that economics is nothing more than the study of people trying to make as much money as they can. Through patient explanations and personal friendships, the two men started getting economists to pay attention to things like herd instincts, irrational fears and poor self-control. If you ignore psychology, they reckon, you can’t predict how people will act. University of Wisconsin finance professor Werner De Bondt calls it “a return to sanity.”
How does behavioral economics apply outside the ivory tower? Consider a simple experiment. Half the students in a class are handed beer mugs. Those with mugs are asked whether they would be willing to sell them back at a given price. The rest are offered the choice of a mug or cash. To an economist, the two questions are identical: what’s the mug worth? But in repeated tests, the people holding mugs name a much higher price than those without. “People aren’t evaluating the mug at all,” Kahneman explains. “if they have the mug, they’re evaluating giving it up. if they don’t have a mug, they’re evaluating getting one. It’s not the mug, it’s the state of having. “That logic that the same item has different value to different people-can move straight from the classroom to the bargaining table: if two parties want to strike a deal, Kahneman says, the easiest strategy is to find agreements that seem like big victories to one side and don’t much matter to the other.
At times, psychology stands economics on its head. Most economists, for example, assume that well-informed people make better choices. Not so, contends MIT’s Richard Thaler. Many long-term investors are scared of risk, he points out. ’their fear may lead them to sell when their monthly statement shows losses, abandoning their long-range strategy. “When you get your monthly statement from Fidelity or Merrill Lynch, there’s a lot of stuff you’d be happier and better off not knowing,” Thaler says. Would fewer statements make for wiser investing? Merrill Lyncb says it may give the idea a test.
Maybe that’s why Wall Street has embraced behavioral economics with a passion. As bond guru Henry Kaufman says, “There’s a whole series of psychoses in markets.” Now those psychoses are being translated into formulas. Take “anchoring,” the psychological finding that people have a hard time abandoning formed opinions. In San Mateo, Calif, money manager Russell Fuller races to buy stocks whose earning jump well above analysts’ estimates. ln theory, those stocks should soar immediately, but in practice the rise is often delayed. “The analysts’ first reaction is ‘The earnings are wrong and my estimate is right’,” Fuller says. New York pension manager Michelle Clayman trades on another well known behavioral foible: excessive optimism. Clayman figures that analysts typically overestimate annual profits by 12 percent - -even when most of the year’s results are already in. Clayman uses past performance to measure that overoptimism, adjusting the numbers downward before picking stocks, Money manager David Dreman says the new research bolsters his view that when the crowd is dumping stocks in a crisis, investors should buy in. “People do tend to overreact.” he says.
Behavioral economics may even solve some of Washington’s economic mysteries. Why, for example, are Americans so mired in debt? The answer, says University of Maryland economist Lawrence Ausubel, is that they are persistent optimists when it comes to paying their monthly bills. “People systematically underestimate their own tendency to borrow on credit cards,” he says. Or take a look at the much-ballyhooed savings shortage. Traditional economics relates savings to such big-picture factors as interest rates and consumer spending. True, Thaler says, but the ease with which people can spend may be just as important; since many folks are short on self-control, retirement accounts that put the money out of reach can ensure that savings will stay saved. “You’re much more tempted to spend money that’s in your pocket,” Thaler says.
Don’t bother looking for a licensed economic shrink just yet. No behavioral economist today has more than a smattering of grad school psych. On the other hand, the highflying math required to do even basic work in finance is beyond the grasp of most psychologists. “Those guys are perceived as outsiders,” says University of Illinois finance professor Josef Lakonishok, a leading behaviorist. “They really don’t know enough about our profession.” Even sympathetic economists complain that psychological insights easily degenerate into psychobabble. “It’s all kind of fuzzy and squishy,” says University of Virginia’s Jonathan Skinner. “How do we write a model that helps capture the fact that we don’t have self-control?”
Will behavioral economics become more than a novelty? “Fad of the month club stuff”, says University of Chicago finance expert Merton Miller. But even at Chicago, it seems to be making inroads. Miller’s colleague and fellow Nobel Prize winner, Gary Becker, says psychological thinking “has had a modest influence” on his studies of issues such as drug addiction. And now the mother church of free-market thinking has given behavioral economics an unexpected stamp of legitimacy. Thaler himself will teach at Chicago next fall.
Every generation brings a new fad (or two) in economic thinking. But few turn out to provide lasting answers. some grand theories that haven’t looked so grand with the passing of time:
KEYNESIANISM: In the 1960s, many economists thought they could constantly tweak taxes and government spending to keep the economy on and even keel. Nice idea. but it proved far easier for politicians to tweak spending up than down.
MONETARISM: Would steady, predictable growth in the money supply bring economic stability with low inflation? in the late 1970s, the Federal Reserve Board gave the idea a try. the answer, though, turned out to be a resounding no.
RATIONAL EXPECTATIONS:this free-market theory blames unemployment on people’s bad guesses about inflation. That means taxes and spending can’t be used to keep the economy on course.
SUPPLY-SIDE ECONOMICS:could lower tax rates bring in so much revenue that the federal deficit would vanish? Economist arthur Laffer’s famous curve said yes. Trouble was, Laffer couldn’t tell us exactly where we were on his curve. The deficit went up, not down–and we’re still paying the bill 14 years later.
NEW KEYNESIANISM: Business-oriented liberals have tried to redefine the government’s role in the economy since the mid-80s. They’ve written great critiques of simplistic free-market policies. but coming up with ideas that work better hasn’t been so easy.
