Behavioural Economics and Regulation

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