Interviewing a Nobel Prize Winner

One of the great pleasures of my career is that I've gotten to interview several Nobel Prize economists, Here's the beginning of an interview I conducted in 2007 with this year's winner, Richard Thaler. He was the inventor, along with psychologist Daniel Kahnemann, of "behavioral economics." This school recognizes that people are not Vulcan-like utility-maximizing rationalists, but human beings--a heresy in orthodox economics. At the time, Obama was looking into his views for economic advice.

This interview with Richard Thaler was published in early 2008 in Weekly Toyo Keizai magazine, one of Japans’ three leading business weeklies.

Richard H. Thaler is considered a pioneer in the fields of behavioral economics and finance. Born in 1945, Thaler his PhD in economics in 1974. Thaler first gained attention between 1987 and 1990 with a regular column, "Anomalies”, published in the Journal of Economic Perspectives. In his column he wrote of individual instances in which economic behavior seemed to violate traditional microeconomic theory. Daniel Kahneman later cited his joint work with Thaler as a "major factor" in his receiving the 2002 Nobel Prize in Economics. Thaler has written a number of books intended for the lay reader on the subject of behavioral finance, including Quasi-rational Economics and The Winner's Curse. His newest book, Nudge, co-authored by Cass Sunstein, is focused on policy proposals. Thaler is currently Robert P. Gwinn Professor of Behavioral Science and Economics, and Director of the Center for Decision Research, Graduate School of Business, University of Chicago. He is also Research Associate, National Bureau of Economic Research, where he is co-director with Robert Shiller of the Behavioral Economics Project.

Toyo Keizai: How does behavioral economics differ from standard economics? What are the differing assumptions about human psychology and behavior?
Thaler: Standard economics assumes that agents in the economy are rational maximizers who are more like robots than humans. And that almost all people, almost all of the time, make choices that are in their best interest—or, at the very least, are better, than the choices that would be made for them by someone else. This assumption is false, indeed obviously false. For one thing, in many areas of the economy, ordinary consumers are novices, dealing with experienced professionals who try to sell them things. Lotteries are successful partly because of unrealistic optimism.

Behavioral economics begins with a more realistic depiction of human behavior. People have limits. They can’t think like computers, they forget things, and they sometimes submit to temptation. As a result, they have biases and make predictable errors.

There is a lot of behavior produced by intuitions and feelings that mislead people. Losing $100 makes most people twice as miserable as gaining $100 makes them happy. This tendency creates a strong desire among people to stick with their current holdings even when these people would be better off if they sold.

Even experts can be fooled. Suppose doctors are told that, after an operation, 90 out of 100 patients are still alive after five years. They are much more likely to recommend the operation than if they are told that 10 out of the 100 patients will die. The outcome is the same. But the way it is presented affects behavior. This is contrary to the “rational optimizer” assumption of standard economics.

Standard economics says that how much people save depends on a rational calculation of how much money they will need over their life cycle, including retirement, compared to how much money they’d like to spend today rather than save. It also assumes that people have enough willpower to save as much as they’d like to save. Yet, in one study, 68% of participants in the American retirement savings plan known as 401(k) said that their saving rate is “too low,” 31% said that their saving rate is “about right,” and only 1% said their saving rate is “too high.” In reality, many non-rational factors affect savings rates. For example, people save more if they get paid bi-weekly instead of weekly. One reason is that twice a year they get three pay checks in one month.

Toyo Keizai: Is behavioral economics just an additional complication in standard economics, or does it lead to widespread and major changes, or even reversals, in forecasts of the economy and in policy responses?
Thaler: Behavioral economics is an enrichment of standard economics. Because the people in the models are more realistically described, the predictions of the models are more accurate. For example, rational models assume that people save just the right amount for retirement. Behavioral models suggest that if people are not given simple ways of saving for retirement, such as through pension plans, they may not save enough, as we are now seeing in America.

Toyo Keizai: When you say "right amount" or "enough," that sounds like your own judgment of what they should save. Do they also save less than they would like to?
Thaler: The evidence is pretty clear that most, though not all, Americans are saving too little, meaning that their standard of living will fall sharply when they retire. Surveys reveal that people know this about themselves. A majority of 401(k) contributors say they are savings too little, and announce their intention to save more next year, but most never get around to implementing that change.

Toyo Keizai: Does behavioral economics imply that there are more cases of the market failing to produce the best result than is presumed in standard economics? If so, does that imply a greater need for intervention by policymakers?
Thaler: Yes and no! Behavioral economics does imply that markets may not lead to the best possible outcomes for consumers. In standard models, consumers always make smart choices, so they choose the products that are best for them. Behavioral models allow for the possibility that people make mistakes, so the product that “wins” the largest market share may not always be the one that consumers would really prefer if they had the time and expertise to make a careful choice. However, this does not necessarily imply a greater need for intervention by policy makers. Since policy makers are human too, they can make things worse if they are not careful. I would say that behavioral economics does not imply more government intervention, but it does imply different types of intervention (as discussed below).

Toyo Keizai: Is there any difference in the type of economists attracted to behavioral economics, such as political orientation, age, or any other difference in background or attitudes? Is it more popular in any particular countries?
Thaler: Behavioral economics is most popular now with young economists. There is an old adage that says that science progresses, funeral by funeral. Behavioral economics is a new field, started in the early 1980s. Most economists who have been trained in the last decade or so are quite open to these ideas, and much of the best work now is being done by economists under 40.

Toyo Keizai: One of your close colleagues and co-authors recently won the Nobel Prize for his work in behavioral economics. What does this say about your insights being incorporated into the mainstream?
Thaler: Daniel Kahneman won the Nobel Prize in 2002 for the work that he did on the psychology of decision making with Amos Tversky. (Tversky died in 1996, and so was ineligible to share the prize with him.) Kahneman and I are very close friends and collaborators. Kahneman and Tversky’s research was psychology, not economics, but it was the underpinnings of what has become behavioral economics. The fact that the Swedish Royal Academy recognized their work has been very helpful in bringing attention to the field, and has probably encouraged even more young economists to join the fun.

Toyo Keizai: In your new book, Nudge, you advocate something called "libertarian paternalism"? Please explain that concept.
Thaler: The idea for our seemingly oxymoronic phrase is that it is possible for organizations, in both the public and private sectors, to devise policies that encourage people to make better decisions without restricting their freedom. A simple example is defining “default options”, that is, what happens when people fail to make an active decision. Normally the default is that if you take no action, nothing happens, but this is not always the case. For example, if you leave your computer alone for a while, it will switch to a screen saver, although you did nothing. Someone has to decide what these default options will be.

One domain in which changing the defaults has had a big impact is in American retirement plans. In most defined contribution plans, such as 401(k) plans, workers have to take some action (i.e. “opt in”) in order to join, by filling out some forms and making some choices. And many workers take years to get around to doing this. In reaction to this, some firms have adopted what has come to be called “automatic enrollment.” When workers become eligible for the plan they receive a letter telling them of this, and alerting them that they will be enrolled in the plan unless they take some action (i.e. “opt out”). This change in policy dramatically increases the rate at which people join the plan.

In one study, participation rates under the opt-in approach were barely 20% after three months of employment, gradually increasing to 65% after 36 months of employment.  But when automatic enrollment was adopted, enrollment of new employees jumped to 90% immediately and increased to more than 98% within 36 months. Very few employees exercise their freedom to drop out of the plan once they have been enrolled.

Toyo Keizai: Given the power of lobbyists and lack of information by voters, etc. why should we expect decisions from government to be "paternalistic?" Or how can they be made more paternalistic?
Thaler: Perhaps we cannot expect the government to act in the best interests of their constituents, but we can encourage them to do so, and we can also put in place methods of keeping better track of what politicians are up to so that we can elect the ones that are more likely to serve society.

Toyo Keizai: Since politicians are elected, can we at least expect them to be more benevolent than, say, mortgage lenders? Does behavioral economics give any clues as to how we can be more effective in "encouraging" politicians to look out more for the interests of their constituents rather than lobbyists?
Thaler: Experience has shown that politicians are not immune to temptation. We are not naïve about this. We think that the best way to get politicians to behave better is to reveal more about what they are doing. And, of course, the political process can be captured. The question is whether we want to try to improve things, or whether we should throw up our hands and say that anything the government does will necessarily make things worse. We think the latter view is excessively pessimistic. Importantly, our proposals do not involve giving the government or regulators more power. Instead we advise governments to set up institutions (choice architectures) that make it easier for consumers to make informed decisions. Thus our strategies are market based. If it had been easier for borrowers to figure out what they were being offered, and to compare the deals by various lenders, the sub-prime crises would have been at least lessened.

Toyo Keizai: You write that sometimes people turn down "free money" in terms of company savings plans. That does sound pretty irrational.
Thaler: In many 401(k) plans, the company offers employers a match. That is, if the employee saves 6% of their salary the company will contribute a matching amount (often 50% of what the employer contributes). Turning this money down is rarely a smart move, except for people with dire liquidity problems. It is nearly 

the mythical free lunch that economists say cannot exist. One extreme example comes from the United Kingdom, where some defined benefit plans do not require any employee contributions and are fully paid for by the employer. They do require employees to take action to join the plan.  Data on twenty-five of these plans reveals that only half of the eligible employees signed up!  This is equivalent to not bothering to cash your pay check.

Toyo Keizai: You also have suggestions about increasing savings rates. Please explain them and how these prescriptions differ from those that might be made without the insights of behavioral economics.
Thaler: In addition to automatic enrollment, that I mentioned above, we describe the plan I developed with my colleague Shlomo Benartzi called Save More Tomorrow. Under this plan employees are invited to join a program in which they commit themselves now to increase the amount they contribute to their savings plan, every time they get a raise. In the first company where we tried this plan, those who joined more than tripled their savings rates. The plan incorporates several features of behavioral economics. We know that people have more self-control for events that are in the future--we plan to start a diet next month, not tonight! We also know that once people are in such a plan, they are likely to stay in it because of inertia. Finally, we know that linking the savings increases to pay increases helps make the plan more attractive because people do not have to experience their take home pay going down. None of these features would be considered important in standard economic theory.

Toyo Keizai: Would behavioral economics help deal with global warming in a way different from standard economics?
Thaler: In Nudge, Cass Sunstein and I argue that the standard economic approach, which is to adopt either a carbon tax or “cap and trade” system, is the correct way to start. But there can be very effective ways to elaborate on this. We know that people are busy can can’t pay attention to everything, so one way to get people to be kinder to the environment is to make their costly actions more salient. For example, in one study researchers found that putting a colored lamp that lit up when a household was using a lot of energy cut consumption rates significantly.

Consider the following information campaigns: (a) If you use energy conservation methods, you will save $350 per year; (b) If you do not use energy conservation methods, you will lose $350 per year. It turns out that information campaign (b) is far more effective than information campaign (a).

Toyo Keizai: How does behavioral economics help us understand the housing bubble and subprime crisis in the US, in terms of both causes and solutions?
Thaler: I think there are two important behavioral factors. First, the bubble itself is an excellent example of “irrational exuberance.”  Many people have been investing in real estate in the mistaken impression that prices can only go up. Clearly, anyone familiar with what happened in Japan in the late 80s knows that real estate prices can get too high, but American investors thought that their own neighborhoods were immune to the laws of supply and demand. As to the subprime crisis, clearly many borrowers were bamboozled by mortgage brokers. The rational agents in economic models would not have been fooled by very low “teaser rates” and would not have taken on loans that they could not afford, but real human borrowers were easily fooled.

Toyo Keizai: Doesn't the notion of exuberance and bubble/bust cycles where people end up buying high and selling low also exist in standard economics?
Thaler: No. In standard economics people have “rational expectations.” They know that prices cannot go up forever. Irrational exuberance is like a fever. You can catch it. Interestingly, it seems to be local. In the late 1980s during the Japanese bubble, most Americans thought that prices were too high in Japan, but Japanese investors did not. Conversely, in 2000, Japanese investors were more pessimistic about the American market for tech stocks than American investors were.

Toyo Keizai: Alan Greenspan refused to use the powers that Congress gave him to regulate non-bank mortgage lenders on issues like downpayments and documentation of ability to pay on the grounds that the market was self-correcting. Would a behavioral economist have recommended a different regulatory approach?
Thaler: Yes. It is clear that many people, including Greenspan, put too much faith in markets. They thought that the lenders had the right incentives to monitor the people they were making loans to. However, since the loans were resold, those who initiated the loans did not have the right incentives. With our without government interference, it seems likely that the investors who buy mortgage securities will insist on better monitoring in the future. I think the main difference in emphasis between a behavioral economist and a neo-classical economist in this sphere would be that behavioralists are more concerned about consumers making mistakes, and would try to create a market environment in which borrowers would be less likely to be taken in by unscrupulous lenders.

Toyo Keizai: Your close colleague, Austan Goolsbee is a key economic adviser to Barack Obama and I believe you have also had talks with him. If he were to win, would behavioral economics play a greater role in White House policymaking than in the past? If so, what are some possible policies that might be guided by behavioral economics?
Thaler: Several of the policies advocated in Nudge have been adopted by the Obama campaign. For example, we have advocated a new way of making it easier to understand the costs and risks of mortgages. We have suggested that lenders would have to give potential borrowers a machine readable file with all the “fine print” included in a spread sheet that could be uploaded (with one click) to web sites that would help borrowers compare loans. We have made similar suggestions about credit cards. The Obama campaign has also adopted the idea of automatic enrollment in many domains including its health care program.

Toyo Keizai:  Do Hillary Clinton and John McCain have advisors influenced by behavioral economics? How about leaders in other countries?
Thaler: I can’t say much about the Clinton or McCain campaigns, but I can say that the concepts of behavioral economics have received bipartisan support in Congress. In 2007 Congress passed something called the Pension Protection Act. One provision of that act was to encourage firms to adopt automatic enrollment and a primitive form of Save More Tomorrow. This provision was popular on both sides of the aisle. I know there is also interest in these ideas in the UK and New Zealand.