The overselling of behavioral economics

November 20, 2013

It’s rare for an Ivory Tower discipline to dazzle Washington, Silicon Valley and Madison Avenue. But behavioral economics has been hailed as a policy cure-all in the U.S., the UK and beyond.

At stake are complex regulatory ailments, from consumer credit and fuel economy to poverty and public health. Remarkably, the marriage between economics and psychology that explores how behavior influences financial decisions also has become a go-to theory for gamification, targeted mobile ads and other tools to attract eyeballs. Even The Colbert Report has weighed in, calling BE’s well-known nudging apparatus “Big Mother.”

Yet BE’s power as a problem-solving miracle might be oversold. A forthcoming paper in the Harvard Law Review by NYU Law School professors Rick Pildes and Ryan Bubb claims that the discipline has led to some ineffectual or harmful policies. Its shortfalls take several forms. One is that BE creates a new set of failures stemming from an individual’s inability to optimize decision-making. Another is that BE can be so bogged down in the appearance of preserving choice that choice is stifled. And BE’s emphasis on disclosure as a means of influencing behavior contradicts its own findings about irrational actors in the markets, including the work that led to Yale economist Robert Shiller’s recent Nobel Prize.

At first glance, the notion almost sounds alarming. How could the widely-embraced darling of once-staunch bureaucrats like Peter Orszag and Cass Sunstein be so gimmicky that it leads to neutral or bad outcomes? And what could be so wrong about a regulation theory that brings together conservatives, liberals, even progressives?

Pildes and Bubb’s meticulous analysis make BE’s shortcomings crystal clear. Consumer credit is a case in point. Instead of outlawing teaser rates and overdraft protection that might lead to reckless spending, consumers get transparency. Then there are the default rules, such as the “sticky opt-out” mortgage system that the Obama administration championed. Lenders are required to offer consumers a standard contract for a so-called plain vanilla, fixed-rate mortgage, but borrowers can opt for one with stricter disclosure requirements aimed at conveying risks and terms presumably more favorable to lenders.

The consequences of BE’s foray into consumer credit are still unknown. The “plain-vanilla” contract was cut from Dodd-Frank because of financial industry complaints. But the act directed regulators to define terms of a residential mortgage, which Pildes and Bubb say might lead to exemption from new rules that require securitizers to retain an interest in the mortgage-backed assets they sponsor. The result could be a version of the “sticky opt-out” mortgage system that encourages comparison-shopping and, presumably, choice while allowing lenders to exploit consumer weaknesses.

BE’s application to consumer credit is baffling, too, because a central tenet is that humans suffer from “bounded rationality” and “bounded willpower.” They might not know or don’t have the capacity to know what the presumably best decisions are based on a lack of knowledge, and they can’t hold themselves back from making the wrong choices. In other words, humans are flawed and not always pragmatic. They make mistakes in judgment and perception. The policy shift from product regulation to disclosure mandates has exploited the very cognitive limitations laid out by BE scholars and has not improved consumer credit woes.

BE is so bogged down in the cloak of choice that options can get stymied. Take retirement savings. Automatic enrollment began in 2006 with the uncontroversial Pension Protection Act. Orszag, then-director of the Retirement Security Project, and his colleagues had turned to scholarly behavioral literature for applying so-called choice-preserving tools to encourage savings. Workers would opt out of retirement plans, rather than opt in.

The idea was well-meaning. Automatic enrollment would benefit people who otherwise might not allot part of their paycheck for retirement funds, while still preserving choice. But a study of one company found that while more people had retirement savings accounts, they saved less than they would have if they had chosen the plan because the default rate was set too low. Another found that overall retirement savings has fallen. Moreover, these retirement policies are tax incentives to the tune of $72 billion, but every $1 of tax expenditure increases total savings by only one cent. “[A]utomatic enrollment in retirement savings plans has functioned, in effect, as a poorly-designed system of mandates,” write Pildes and Bubb.

There are times when BE has been applied and the analysis has been less than rigorous. Hard to believe, but the nuances of how nudges function do not always seem to seriously take into account why people act the way they do. So it’s almost impossible to know whether crucial policy prescriptions that challenge traditional solutions involving decision-making and choice are the way to go.

Paternalism is a concept that has made Americans wary since the revolution. Americans prize self-determination, even when it is expressed in self-destructive ways. The irony of BE is that it can rein in the very autonomy it seeks to preserve, if quietly, without clear-cut advantages to the social welfare. And what’s the point of paternalism if it doesn’t even get results?

PHOTO: Director of the Office of Management and Budget Peter Orszag testifies about the Fiscal Year 2011 Budget and Economic Outlook at the U.S. House Appropriations Committee on Capitol Hill in Washington, March 16, 2010.    REUTERS/Larry Downing


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Sounds a lot like this is related to the insurance policy cancellations wrt the ACA. People do not have the information or foresight needed to make optimal insurances choices–that is essentially what insurance is all about, protecting us from the unknown.

Now we have a law that tries to regulate the insurance market instead of relying on disclosure. People are mad that their policies are getting cancelled, even though those policies were likely inadequate to begin with.

Posted by Bzupnick | Report as abusive

It all sounds like broad academic generalizations that attempt to avoid thinking about the real situation at hand. They should go back to their ivory towers where they can’t do much harm. Their students will ignore them anyway.

Posted by Jim1648 | Report as abusive

Harvard Law Review
Deregulation: A Major Cause of the Financial Crisis
The articles in this issue explore the importance of government regulation of business in protecting the health and welfare of the American people. –

SEC Chairman Cox Admits Deregulation Caused Crisis
Bush Appointee Christopher Cox admitted the credit crisis was due to deregulation.

Posted by DurtBagg | Report as abusive

Garbage in, garbage out. Since the “psychology” that they have been using is unscientific crap devoid of the knowledge that humans evolved, they fail over and over. Yes, even human brains and behavior evolved, they are not infinitely flexible, and we did not evolve to be “rational actors.” Gad Saad has been working the last decade, basically alone, to establish what the marriage of economics with a real scientific understanding of human behavior will look like. Until his work spreads into the halls of power, we will have policies based on absurd impossible notions that are passed off as “psychology.”

Posted by tribalpeace | Report as abusive

Academics such as Diener, Tversky and Kahneman generated some significant insights in the early days of behavioral economics (late ’70s/early ’80s). Unfortunately, behavioral economics has devolved into a discipline that attempts to force psychological/human behavioral effects into supporting 19th-century neoclassical economic theory, theory that was created a priori, with no empirical evidence supporting it then, or now. The goal of behavioral economics has become one of trying to legitimize the emissions coming from the neoclassical economics bull. Sad.

Posted by TheSmallR | Report as abusive