Is economics becoming a branch of psychology?

I began pondering this question while reading Misbehaving, Richard Thaler’s entertaining and somewhat triumphalist account of his career in helping to establish behavioral economics. The fact that Thaler was made president of the American Economic Association in 2015 might signal growing acceptance within the profession that economics should be built on the insights that psychology provides about human motivation and behaviour, rather than on conventional neoclassical assumptions about individual rationality. For those who accept Lionel Robbins famous definition of economics as “a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses” and consider the rise of behavioral economics in that context, it would not involve a huge leap to suggest that all economics is behavioral economics, and therefore a branch of psychology.

It is acknowledged that behavioral economists seem to behave in many respects more like economists than psychologists, but that could, perhaps, be interpreted as a clever use of psychology. In the absence of behavioural economics, it would have been easy for economists to continue to ignore psychologists who suggest that the it is not realistic to assume that individuals maximize utility. It has been much more difficult for economists to ignore one of their number who makes the same point, while suggesting that the assumption that humans behave like mythical Econs should be retained as a benchmark against which actual human behaviour should be assessed. Early in the book Thaler writes:

“Theories based on the assumption that everyone is an Econ should not be discarded. They remain useful as starting points for more realistic models” (p7).

When it suits his purpose I think Thaler also uses the conventional utility maximizing assumption as a normative benchmark (just as many economists have wrongly used the concept of perfect competition as a normative benchmark). Although he claims that it “has never been my point to say that there is something wrong with people”, a lot of his efforts have been directed toward suggesting that humans make systematic cognitive errors that can be ameliorated by the “nudges” provided by wise government agencies. I have previously argued (here and here) that while the libertarian paternalism Thaler advocates is preferable to coercive paternalism, people need to be vigilant to ensure that they not being nudged toward choices that are contrary to their interests. We need apps to advise us whether or not to accept the default options offered to us by “choice architects”.

I cannot resist feeling bemused that during the period while psychology was gradually being welcomed into economics, like a Trojan horse, neoclassical economists were widely held to be behaving like imperialists, invading the subject matter of other social sciences, following the leadership of Gary Becker. Paradoxically, using the neoclassical assumption of individual welfare maximization, economists have been able to provide some useful insights to the study crime, the family, education and many other topics. Even when disciplinary overreach was fairly obvious, as in the theory of rational drug addiction, it has been plausibly argued that people like Becker challenged researchers to develop alternative theories and to confront those theories with data. The challenge of economists’ imperialism lives on in popular discourse, such as Freakonomics, as well as universities.

Perhaps the Trojan horse of behavioural economics will thrive within the broad domain of economic imperialism. We might see a convergence of psychology and economics in the study of a wide range of issues.

However, as I see it, the fundamentals of economics will continue to remain largely unaffected by both behavioural economics and the conventional neoclassical assumptions about individual welfare maximization. The theory of choice is worthy of study, but it is not as central to economics as it has commonly been claimed to be. Lionel Robbins definition of economics as being about solving allocative problems has tended to distract from the more important role of economists in studying “the propensity in human nature” to “truck, barter, and exchange one thing for another” and how this promotes “general opulence” or human flourishing.  The quoted words were, of course, used by Adam Smith in The Wealth of Nations.

In his article “What should economists do?”, published in 1964, James Buchanan argued that the theory of choice should be removed from “its position of eminence in the economist’s thought processes”. He suggested that economists should concentrate their attention on human behaviour in market relationships and other voluntaristic exchange processes, and upon the various institutional arrangements that can arise as a result of this form of activity.

Since Vernon Smith has studied how such institutions can emerge in experimental settings, it is fitting that he should be given the last word here:

“Individual choice … is not where the action is in understanding economic performance and human achievement. … The main work of socioeconomic systems is in specialization and the exchange systems that make possible the wealth they create, not the minutiae of choice and preference representation. The functioning of these systems is far beyond the field of vision of the individual, but it should not be beyond the vision of economic science” (Rationality in Economics, p 156). 

Postscript:

By coincidence, not long after I had finished writing this post I was enjoying my daily quota of Bourgeois Equality by Deirdre McCloskey, when came across this:

“Nowadays the behavioral economics of, say, Dan Ariely does a job of demolishing claims of individual rationality in moderns. Yet it too commits the Weberian mistake of focusing on individual psychology instead of group sociology and market economics. The experimental economics of Vernon Smith, Bart Wilson, Erik Kimbrough, and others, by contrast, works always with groups, showing that a wisdom of crowds often prevails over psychological shortsightedness and calculative confusion. And by the way, it makes a good case that property arises without the help of the state or the nudging of the clerisy” (p 282).

Why has Australia prospered much more than Argentina?

In the first half of the 19^th Century the Australian and Argentinian economies were similar in many respects. Both countries were being settled by European migrants and their economies were heavily dependent on pastoral activities. Around 1900, per capita GDP levels in Argentina were thought to be not far below those in Australia (see the chart below). Since then, while Australia has prospered to much the same extent as other relatively wealthy countries, Argentina has slipped behind.

Ian McLean’s attempt to explain why Australians have prospered to a much greater extent than Argentinians is to my mind the most interesting feature of his book, Why Australia Prospered (2013).

Part of Ian’s explanation did not come as a surprise to me, but nevertheless deserves to be repeated - often! There have been periods during the last century when inappropriate institutions and policies have threatened to retard the improvement of Australian living standards (e.g. the 1970s) but long-run stagnation was avoided because appropriate economic reforms were made and sustained. As Ian comments: “This contrasts with the historical record of Argentina” (p 252).

A deeper, and more novel, aspect of Ian’s explanation is his speculation that the past willingness of Australians to change institutional arrangements when future prosperity has been threatened is linked to the emergence among 19^th century Australians of a democratic and egalitarian temperament, and its persistence since then. Ian notes that there were strong economic forces opposed to the emergence of such culture in Australia because the initial distribution of ownership of pastoral land - the principal basis of wealth in the economy - was highly unequal. In terms of the analysis of Stanley Engerman and Kenneth Sokolov, the economic power acquired by the wealthy elite could have been expected to have been employed to shape political and social institutions as occurred in Latin American countries, entrenching inequality and resulting in ongoing growth-stunting distributional conflict. According to Ian’s speculations, Australia avoided a long period of squattocracy (oligarchic government by wealthy land owners) only because the British were still in control at the critical point in the 1850s and were able to determine the nature and timing of self-government.

This story challenges some of my preconceptions. I like to think of the squatters as heroes of free enterprise rather than as oligarchic rent-seekers. But I guess few humans are able to resist the temptation to exercise political power in their own interests when the opportunity presents itself. The squatters would have had little difficulty in believing that they were serving the common good by seeking to entrench their dubious property rights and encourage ongoing importation of cheap labour for use on their properties.

The idea that the British government was acting in Australia as an enlightened force promoting democratic ideals might require some explanation.  Ian points out that British attitudes and policies towards the colonies had been shaped by the loss of American colonies and by political instability in Canada. He also notes the existence of domestic pressures for institutional change:

“The attitudes and aspirations of the flood of immigrants arriving after the discovery of gold reflected those of mid-Victorian Britain where reform of the corrupt and class-based political system and concern at social and economic inequalities were much in evidence” (p 252).

Ian McLean’s account of Australian economic history shows that it would be as difficult to sustain the view that Australia has prospered because the heroes of free enterprise have consistently won political battles against the proponents of egalitarianism, as it would be to sustain the view that Australia has prospered because government interventions have consistently been benign in this country. Early establishment of democratic institutions seems to have acted as an important safety valve reducing the potential for distributional conflict, even though it brought with it restrictions on economic freedom, such as trade protectionism, that were later to hinder economic growth. Over the long term, a democratic and egalitarian culture has so far helped Australians to restore and maintain sufficient economic freedom to ensure their ongoing prosperity. 

Is Australian housing more than 40% over-valued?

Source: Australian Bureau of Statistics

A recent article in The Economist suggests that “housing appears to be more than 40% overvalued in Australia, Britain and Canada” (“Hot in the city”, April 2, 2016 - possibly gated). This claim is based on the extent that the ratios of prices to disposable incomes and prices to rents are above their long term averages in those countries. By contrast, according to The Economist, housing prices in the United States are currently at “fair value” because those indicators are close to their long run average.

When they talk about “fair value” I guess what the authors of The Economist article have in mind is an equilibrium price that may differ from current market prices.  That raises some thorny conceptual issues, but I am prepared to accept that markets are sometimes affected by the irrational exuberance or pessimism of large numbers of investors.

The Economist has been using the same methodology for quite a few years now to suggest that housing prices are overvalued in countries in which they have risen strongly since the GFC.

When I wrote in 2011 about a previous article in The Economist using this methodology I pointed out that it was unrealistic to expect average rental yields (the inverse of the house price to rent ratio) in Australia to return to its long term average over the period since 1975 because over the first half of that period high nominal interest rates were suppressing demand for housing. As inflation rates and interest rates came down, housing affordability improved markedly during the 1990s, but this led to increased demand for housing, a sharp rise in house prices and a decline in rental yields. What we were seeing was a return to normality rather than the emergence of a house price bubble.

The Economist has published an infographic (ungated) which neatly illustrates how the ratios of prices to disposable incomes and prices to rents are currently above their long term averages in Australia, Britain and Canada. However, their infographic also illustrates the potential for large errors to be made by assuming that long term averages of house price to rent and house price to income ratios represent equilibrium prices. If you look at movements in the ratios of prices to disposable incomes and prices to rents over the whole period 1970 to 2016, you will notice that those ratios for Australia and Canada were well below the corresponding ratios for the US in the 1970s and ‘80’s. The same was true for Britain in the ‘90s. Even if actual price to income and price to rent ratios were currently the same in all four countries, the ratios for Australia, Canada and Britain could still be expected to be above their long run averages.

So, what does a comparison of actual ratios for Australia, Canada, Britain and the United States show? I haven’t attempted a complete assessment, but the latest data from Global Property Guide (GPG) on gross rental yields suggests yields of 4.4% for Australia (Sydney), 4.4% for Canada (Toronto), 3.2% for the UK (London) and 3.9% for the US (New York). The GPG data for the US relates to Manhattan which might be perceived by investors to offer better prospects for capital gains than most other localities in the US. The Economist’s data on price to rent ratio’s for the US implies a much higher gross rental yield for New York (about 7%) and even a somewhat higher yield for San Francisco (about 5%).

Given current and prospective interest rate levels, those comparisons do not seem to provide much evidence of irrationality in housing prices in any of those countries. It seems to me that there is no more reason to think housing investors in Australia, Canada and Britain have been irrationally exuberant in recent years than to think those in the United States have been irrationally pessimistic.  

What is the objective of superannuation?

This post is prompted by the Australian government’s discussion paper entitled “Objective of Superannuation” released yesterday. The government is raising the matters as part of a consultation process prior to introducing legislation to specify the objective of superannuation in legislation. The discussion paper uses the word “enshrine”, rather than “specify”, but that seems inappropriate.

Unfortunately, the paper fails to point out that in specifying the objective of super the government is (or should be) focused on public policy, rather than the wide range of different objectives of different individuals and firms with an interest in super. Some people use super to build wealth to pass to their children. Some people use it to save for retirement. I expect that many people don’t have a clear objective in mind, but view super as a useful savings mechanism. Employers may view super as a way of attracting staff or ensuring that valued staff are able to live comfortably after retirement. The financial institutions that provide superannuation products have different objectives again.

The question the legislation should be trying to clarify is:  What is the objective of government legislation with respect to superannuation?  If we have an answer to that question we may be in a better position to consider questions such as whether there might be a case for individuals to continue to be encouraged, nudged or even compelled (as at present) to save via superannuation .

The government proposes to legislate the objective recommended by the Financial System Inquiry:

“To provide income in retirement to substitute or supplement the Age Pension”.

In my view that is a sensible public policy objective. The government should be encouraging people to become more self-reliant rather than expecting taxpayers to support them in their old age. This is particularly important given the projected increases in the government spending on pensions in coming decades and the many other burdens being placed on taxpayers.

The subsidiary objectives raised for discussion tend to cloud the issues. For example, “facilitating consumption smoothing over the course of an individual’s life” is presumably also an objective of the age pension, unemployment benefits and other welfare payments. Some other suggested subsidiary objectives relate to prudential regulation and fiscal policy.

A potential problem I see with the proposed clarification of the objective is that pursuit of that objective in isolation could result in a less efficient tax system than we currently have. 

Even though they do not do as much as they should to substitute or supplement the aged pension, the current tax concessions for super do reduce the bias against savings and investment under the income tax system. The concessions reduce the extent that individuals who save, and re-invest income from their savings, pay a higher lifetime tax bill than people with similar earnings who choose to save less. The bias against savings and investment will be exacerbated if super tax concessions are reduced without more fundamental reforms being taken to improve incentives for savings and investment.

I was also concerned about this when writing about the potential for tax reform on this blog in April last year. Whilst suggesting that it made sense to include reductions in super tax concessions as part of a tax reform package, I hoped that the government did not forget to obtain a substantial reduction in tax on capital incomes as a quid pro quo.

It will be interesting to see whether specifying a sensible objective for superannuation policy helps to achieve a better overall tax policy outcome.