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October 25, 2004
Anyone who spends any amount of time listening to arguments about political economy will end up getting an earful about the efficient markets hypothesis (briefly, the theory that market prices reflect all available information).
This is not a popular theory with many segments of the commentariat, mostly those who are unhappy with the value the markets have assigned to something--such as their labour. Thus one is always seeing stories about the death of efficient markets; such reports, like those of the death of Mark Twain, are generally greatly exaggerated.
After Vernon Smith and Daniel Kahneman won the Nobel Prize for behavioural economics (briefly, the study of ways in which market actors, a.k.a people, behave irrationally), it became the Great White Hope for finally toppling the hated edifice. There are two problems with this. The first is that even though people can be observed behaving irrationally, EMH still has pretty good predictive value. The second is nicely explained by Zimran Ahmed who, like me, is an alumnus of the University of Chicago Graduate School of Business, the quasi-official Home of the Efficient Markets Theory.
It is true that behaviorists' ideas have become mainstream (at least at Chicago), but this does not mean what people think it means.
Firstly, the truth is that the Chicago School of Economics was always aware of and looking for explanations for market bubbles -- and obvious (in hindsight) demonstration of market irrationality. More obscure phenomena, such as a "equity risk premium" similarly eluded free market explanations. Behavioral experiments shed light on these and so provide answers to key, outstanding economic questions.
Secondly, the truth is that the cognitive biases identified by Thaler et al do not vanish once the decision moves from the market to the committee. Left-wing folks have gravitated towards behavioral economics because they see it as a way to escape the defeatest free-market prescriptions of classical economics. Unfortunately, behavioral economics says that market participants can be irrational because they are human, which is easily extended into committee members can be irrational because they are human. Behavioral economics does not allow for the benevolent central planning that seems to attractive to many.
So what is it good for? According to Thaler and U Chicago law professor, the provocatively titled Libertarian Paternalism.
What a great title.
Libertarian paternalism takes behavioral insights -- such as default choices matter -- and marries that with the fierce individualism at the heart of libertarianism. So, you let people do what they want, but you work hard to make sure that the defaults are right. This has the benefit of making the default choice (and there must always be a default choice) considered instead of random, but you mitigate the danger of the committee getting it wrong by letting people change the choice if they want.