There was a long piece in the
New York Times last week about Britain's eager adoption of the approach to regulation and law reform set out by Richard Thaler and Cass Sunstein in
Nudge:
Britain's Ministry of Nudges.
Here is an extract:
It is an American idea, refined in American universities and popularized in 2008 with the best seller “Nudge,”
by Richard H. Thaler and Cass R. Sunstein. Professor Thaler, a
contributor to the Economic View column in Sunday Business, is an
economist at the University of Chicago, and Mr. Sunstein was a senior
regulatory official in the Obama administration, where he applied
behavioral findings to a range of regulatory policies, but didn’t have
the mandate or resources to run experiments.
But it is in Britain that such experiments have taken root. Prime Minister David Cameron
has embraced the idea of testing the power of behavioral change to
devise effective policies, seeing it not just as a way to help people
make better decisions, but also to help government do more for less.
In 2010, Mr. Cameron set up the Behavioral Insights Team
— or nudge unit, as it’s often called. Three years later, the team has
doubled in size and is about to announce a joint venture with an
external partner to expand the program.
The unit has been nudging people to pay taxes on time, insulate their
attics, sign up for organ donation, stop smoking during pregnancy and
give to charity — and has saved taxpayers tens of millions of pounds in
the process, said David Halpern, its director. Every civil servant in
Britain is now being trained in behavioral science. The nudge unit has a
waiting list of government departments eager to work with it, and other
countries, from Denmark to Australia, have expressed interest.
In fact, five years after it arrived in Washington, nudging appears to
be entering the next stage, with a new team in the White House planning
to run policy trials inspired in part by Britain’s program. “First the
idea traveled to Britain and now the lessons are traveling back,” said
Professor Thaler, who is an official but unpaid adviser to the nudge
unit. “Britain is the first country that has mainstreamed this on a
national level.”
One interesting issue, however, is whether the insights of behavioural economics can and should be applied to the regulators as well as the regulated. Each of the "tics" to which we are susceptible as individuals are capable of plaguing us just as much at work as at play, as
James C. Cooper argued last month in
Behavioural Economics and Biased Regulators:
Regulators are likely to use heuristics—mental shortcuts—to form what
they consider the optimal long-run policy choice. Behavioral economics
demonstrates that these shortcuts, although timesaving, may lead to
systematically flawed decision-making. Experimental research has
documented the existence of several of these flawed heuristics.
The
availability heuristic, for example, causes people to overemphasize
recent and particularly salient events when estimating the likelihood
and cost of those events in occurring in the future. The
hindsight bias leads people to overestimate the ex ante probability of
an event occurring given that it has actually occurred.
Finally, optimism bias causes individuals to underestimate their own
probability of experiencing a bad outcome. In addition, regulators may
suffer from myopia, which can arise due to cognitive inabilities to
process life-cycle costs or from self-control problems.
Regulators
who suffer from these cognitive flaws are likely to commit systematic
errors when forming policies. Myopic regulators, for example, will focus
excessively on short-run considerations, such as measurable increases
in activity that are clearly associated with their tenure, rather than
optimal long-run considerations that may suggest pursuing policies that
pay off only after the regulator’s tenure. The availability bias,
moreover, would cause regulators to overestimate the future risk of
certain bad outcomes that may have recently occurred, and thus take too
much precaution to avoid them. In the context of the
quasi-negligence determinations involved in certain consumer protection
violations, for example, hindsight bias is likely to cause an agency to
look more skeptically on practices that led to harm ex post.
Finally, optimism bias may cause regulators to hold an unduly
optimistic view of the likely success of a policy choice. Apart from
flawed heuristics and myopia, there is a class of cognitive errors that
tends to wed people irrationally to the status quo. The
endowment effect, for example, leads experimental subjects to require
more compensation to part with an endowment than they are willing to pay
to gain it.
I touched on the times of behavioural tics and bounded rationality in a review of Andrew Ross Sorkin's book on the credit crunch (
Too Big to Fail) a couple of years ago:
It
bears mentioning that regulatory bodies are composed of individuals and
are also subject to these cognitive tics. Once limitations on human
cognition are understood, it is not as difficult to appreciate why
Ireland’s Financial Regulator, and equivalent American bodies, did not
intervene in markets that appeared to be running smoothly. Once the
markets ground to a half, hindsight choice bias worked in the opposite
direction. People roamed the streets, waving copies of Nassim Taleb’s The Black Swan
or Morgan Kelly’s opinion pieces like Chamberlain’s piece of paper,
declaring wildly that it had been perfectly obvious all along. It rarely
is, as Ross Sorkin’s pitch-perfect description of the bafflement on a
besieged Wall Street, traumatised by the emergence of the possibility of
even the leading investment bank, Goldman Sachs, going to the wall
demonstrates.
Other
phenomena afflict government agencies. Regulatory arteriosclerosis can
set in over time. An initial burst of enthusiasm – such as that being
shown at present by Professor Patrick Honohan, the new governor of the
Irish Central Bank – leads to creative regulation, but as the years pass
the enthusiasm begins to wane and the once vigorous body expends its
decreasing energies on maintaining its position rather than innovating. A
more troubling phenomenon is that of agency capture, the idea that
government bodies tend to further the interests of regulated bodies,
rather than the interests of the public. Agency capture is not as
sinister as it sounds. Regulators are closely identified with the
industry they regulate and because the success of the industry reflects
well on them, they will tend naturally to promote the interests of the
industry. If banks’ profits are increasing and share values are
rocketing, a regulator will be loath to intervene. And if house prices
are rising and the downtrodden can fulfil their ambition to own a home, a
regulator is more likely to facilitate more lending than to call a halt
to the extension of easy credit.
- See more at: http://www.drb.ie/essays/cognitive-tics-of-the-herd#sthash.5xjnfX39.dpuf
Other cognitive tics affect how individuals process
information. Through the operation of the availability heuristic, important,
high-profile events are given more weight than recurring, low-profile events.
The collapse in airline travel after the 9/11 attacks is a good example. Did
flying suddenly become more dangerous? Surely not, but the endless rewinds of
planes crashing into buildings made the event a salient one, apt to influence
people not to fly. Consider, by way of contrast, road fatalities, which are
generally events of low salience and do not exert great influence on
individuals’ propensity to drive. During the 1990s and 2000s, all the happy
stories about individuals buying their beautiful first homes, about investors
making millions in the markets and Wall Street executives pocketing enormous
pay packets triggered the availability heuristic at all levels of society. A
phenomenon known as hindsight choice bias contributes something to the
availability heuristic. Individuals create narratives to explain past events.
In those narratives, happy events are more likely to feature. The five friends
who reaped huge capital gains when they sold their houses loom larger than the
one friend who couldn’t meet the mortgage repayments. In the financial world, the
collapse of Long Term Capital Management is discounted in favour of tales of
the derring-do of Bear Sterns and Lehman Brothers. We all write our own Whig
histories.
It bears mentioning that
regulatory bodies are composed of individuals and are also subject to these
cognitive tics. Once limitations on human cognition are understood, it is not
as difficult to appreciate why Ireland’s
Financial Regulator, and equivalent American bodies, did not intervene in
markets that appeared to be running smoothly. Once the markets ground to a
half, hindsight choice bias worked in the opposite direction. People roamed the
streets, waving copies of Nassim Taleb’s The
Black Swan or Morgan Kelly’s opinion pieces like Chamberlain’s piece of
paper, declaring wildly that it had been perfectly obvious all along. It rarely
is, as Ross Sorkin’s pitch-perfect description of the bafflement on a besieged
Wall Street, traumatised by the emergence of the possibility of even the
leading investment bank, Goldman Sachs, going to the wall demonstrates.
...
The view of government agents as knights in shining armour
often takes the rosier perspective of perfect rationality, or even bounded
rationality. In 2008 though, the government muddled its way through. Individual
firms were initially the focus of attention: first Bear Sterns, then Lehman
Brothers and Merrill Lynch (eventually rescued by Bank of America). Concerted
efforts were made to save the endangered firms, but it was not until the
collapse of Lehman Brothers imperilled the entire financial system that
Paulson, Geithner and Ben Bernanke, chair of the Federal Reserve, took a
broader view. The Troubled Asset Relief Program (TARP) then emerged. Although
some of Paulson’s staff members had outlined a basic TARP a few months
previously, those calculations were of the “back of an envelope” variety.
Initially, the idea behind the TARP was similar to the one underpinning Ireland’s
National Asset Management Agency (NAMA). If lines of credit were becoming
frozen because everybody knew that there were toxic assets in the financial
system but nobody knew exactly who held the toxic assets, how much the toxic
assets were worth, what the effect was on the value of non-toxic assets, or how
the good could be separated from the bad, it followed that the financial system
could not be restored to full health without removing the toxins. Moreover,
because valuing the toxic assets was so difficult, purchasers were reluctant to
buy them. But by setting up some sort of government-led auction to establish a
floor price for the toxic assets, perhaps the value of the assets could be
ascertained and boosted, ultimately allowing the toxins to be flushed out and
credit to begin flowing through the system again. TARP, like NAMA, was a
synoptic response to the toxic asset problem. Tellingly, it was only in the
face of a full-blown crisis that TARP emerged as the solution: “The entire
economy, [Paulson] said, was on the verge of collapsing”. Until that point, it
had been incrementalism all the way. Similarly, in Ireland, NAMA came after the bank
guarantee, the nationalisation of Anglo Irish Bank, and the pumping of capital
into Bank of Ireland and Allied Irish Banks.
It
bears mentioning that regulatory bodies are composed of individuals and
are also subject to these cognitive tics. Once limitations on human
cognition are understood, it is not as difficult to appreciate why
Ireland’s Financial Regulator, and equivalent American bodies, did not
intervene in markets that appeared to be running smoothly. Once the
markets ground to a half, hindsight choice bias worked in the opposite
direction. People roamed the streets, waving copies of Nassim Taleb’s The Black Swan
or Morgan Kelly’s opinion pieces like Chamberlain’s piece of paper,
declaring wildly that it had been perfectly obvious all along. It rarely
is, as Ross Sorkin’s pitch-perfect description of the bafflement on a
besieged Wall Street, traumatised by the emergence of the possibility of
even the leading investment bank, Goldman Sachs, going to the wall
demonstrates.
Other
phenomena afflict government agencies. Regulatory arteriosclerosis can
set in over time. An initial burst of enthusiasm – such as that being
shown at present by Professor Patrick Honohan, the new governor of the
Irish Central Bank – leads to creative regulation, but as the years pass
the enthusiasm begins to wane and the once vigorous body expends its
decreasing energies on maintaining its position rather than innovating. A
more troubling phenomenon is that of agency capture, the idea that
government bodies tend to further the interests of regulated bodies,
rather than the interests of the public. Agency capture is not as
sinister as it sounds. Regulators are closely identified with the
industry they regulate and because the success of the industry reflects
well on them, they will tend naturally to promote the interests of the
industry. If banks’ profits are increasing and share values are
rocketing, a regulator will be loath to intervene. And if house prices
are rising and the downtrodden can fulfil their ambition to own a home, a
regulator is more likely to facilitate more lending than to call a halt
to the extension of easy credit.
- See more at: http://www.drb.ie/essays/cognitive-tics-of-the-herd#sthash.5xjnfX39.dpuf
It
bears mentioning that regulatory bodies are composed of individuals and
are also subject to these cognitive tics. Once limitations on human
cognition are understood, it is not as difficult to appreciate why
Ireland’s Financial Regulator, and equivalent American bodies, did not
intervene in markets that appeared to be running smoothly. Once the
markets ground to a half, hindsight choice bias worked in the opposite
direction. People roamed the streets, waving copies of Nassim Taleb’s The Black Swan
or Morgan Kelly’s opinion pieces like Chamberlain’s piece of paper,
declaring wildly that it had been perfectly obvious all along. It rarely
is, as Ross Sorkin’s pitch-perfect description of the bafflement on a
besieged Wall Street, traumatised by the emergence of the possibility of
even the leading investment bank, Goldman Sachs, going to the wall
demonstrates.
Other
phenomena afflict government agencies. Regulatory arteriosclerosis can
set in over time. An initial burst of enthusiasm – such as that being
shown at present by Professor Patrick Honohan, the new governor of the
Irish Central Bank – leads to creative regulation, but as the years pass
the enthusiasm begins to wane and the once vigorous body expends its
decreasing energies on maintaining its position rather than innovating. A
more troubling phenomenon is that of agency capture, the idea that
government bodies tend to further the interests of regulated bodies,
rather than the interests of the public. Agency capture is not as
sinister as it sounds. Regulators are closely identified with the
industry they regulate and because the success of the industry reflects
well on them, they will tend naturally to promote the interests of the
industry. If banks’ profits are increasing and share values are
rocketing, a regulator will be loath to intervene. And if house prices
are rising and the downtrodden can fulfil their ambition to own a home, a
regulator is more likely to facilitate more lending than to call a halt
to the extension of easy credit.
- See more at: http://www.drb.ie/essays/cognitive-tics-of-the-herd#sthash.5xjnfX39.dpuf
