Nudge and Predictably Irrational

13 January 2010/No Comments
By Nick Dunbar
cover of Nudge by Thaler and Sunstein
cover of Predictably Irrational by Dan Ariely
Predictably Irrational

Nudge: Improving Decisions About Health, Wealth and Happiness by Richard Thaler and Cass Sunstein ( Yale University Press, 2008)
Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely (Harper Collins, 2008)

Just over a year ago, I made a rough estimate of the size of my income tax bill that I would be paying twelve months later (i.e. now). Deciding to set the money aside in a savings account, I opened a one-year term deposit with a bank in Glasgow via the post. It was just before the Bank of England cut its rate to 0.5%, so the one-year deposit rate was still pretty good. Feeling pleased at my own self-control, I sat back and waited. Sure enough, my tax estimate was fairly accurate, and last week I prepared to cash my deposit and pay the Inland Revenue.

However, I then noticed a letter from the Glasgow bank that had arrived a few weeks before Christmas and somehow got overlooked. It announced a change in ‘terms and conditions’. Unless I replied within five days, a new ‘default option’ would be applied to my account. The bank would automatically reinvest my money for another year, and if I wanted to withdraw it (as I had planned to do), I would be subject to swingeing penalties. When I read this letter a few days ago, it was way past the bank’s deadline and I am now having a discussion with the bank.

Had I not just finished reading a pair of behavioural economics books, I might not have given this episode any further thought. But the word ‘default’ caught my eye. Cass Sunstein and Richard Thaler use it frequently in their book Nudge, as part of a toolkit in what they call ‘libertarian paternalism’. As a corrective to consumer procrastination, they argue for default options as means of ensuring that people save enough for retirement without curtailing their freedom.

Would Sunstein and Thaler have approved of my bank automatically reinvesting my deposit? Most savers might want to reinvest but would forget to do so, forgoing the benefits of compound interest. Perhaps my bank was paternally ‘nudging’ me in the right direction—well, not actually me, but rather an ‘average me’ that its computers had modelled.

As Sunstein and Thaler would put it, this ‘average me’ resembles Homer Simpson and either procrastinates or makes lots of self-gratifying, short-sighted mistakes. The real me that planned in advance to pay his taxes is a so-called ‘econ’ resembling Star Trek’s Dr Spock. My irritation at my bank’s behaviour is a small cost to be paid by the rational minority for a broader social benefit enjoyed by the Homers (or ‘humans’) as the authors label them.

If you read Nudge and its behavioural economics bedfellow Predictably Irrational, you will find yourself thinking a lot along these lines. Both books provide excellent summaries of the decades of psychology research showing that the Homer Simpson vs Dr Spock divide really exists—not just between different groups of people but within all of us, as a kind of Jekyll and Hyde split personality. Building on the success of Steven Levitt’s bestselling Freakonomics (2005), the books give the lay reader a good grounding in phenomena such as the endowment effect, and heuristics such as anchoring, framing, availability and representativeness.

The authors are well qualified to provide this account. Thaler is one of the founders of the field, and his joint effort with Sunstein, a well-known academic jurist with a behavioural slant, has something of a dream team quality. Ariely is not quite in their league academically, but makes up for it with an engaging and entertaining style (see his lectures on the TED website) that immerses you in his life as a behavioural economics researcher.

Motivating both books is a moral question. Looming over the entire field of behavioural economics is the previous century’s work on rational choice, probability and classical economics with its self-interested agents. You can have fun with demolishing homo economicus as a utopian fantasy out of touch with reality, but after you have done that, what next? Experimental demonstrations of widespread human irrationality and biased judgement don’t change the fact that rational choices do exist if one can take them.

Sunstein and Thaler tackle this question from a top-down perspective. They are particularly good at analysing where market mechanisms fail consumers. It’s those infrequent, delayed benefit decisions such as choosing a mortgage or retirement plan that confuse most people, leaving them wide open to ‘rent-seeking’ services that exploit their confusion. Financial services practitioners will understand that dilemma all too well, and the book underlines the importance of financial consumer regulation, something which barely exists in the United States.

Acknowledging the Manichean politics of the US, Thaler and Sunstein offer a ‘third way’. Experts should be capable of figuring out the rational choices in a given situation, so their policy solution is to square this expertise with individual freedom using the nudge mechanism. Optimistically, they hope to bridge the political divide.

Ariely takes a bottom-up perspective to the same moral question, deploying the same behavioural economics insights as a kind of self-empowerment tool for individuals. By teaching his readership about their ‘predictably irrational’ day-to-day decisions, Ariely delivers his own positive message.

‘There is a silver lining’, he writes. ‘The fact that we make mistakes also means that there are ways to improve our decisions ““ and therefore there are opportunities for “free lunches”.’ In other words, Ariely proposes nurturing our inner Dr Spock as a kind of hedge fund manager who arbitrages the inner Homer Simpson and improves our overall happiness.

One can quibble that this upbeat message is slightly oversold by Ariely and his publishers. Many of the insights of behavioural economics have been known for centuries, at least anecdotally. Even that alleged arch-rationalist Adam Smith knew about them. After all, doesn’t the proverb ‘a bird in the hand is worth two in the bush’ say something similar to the endowment effect?

A cynic might question how much value lies in rediscovering and professionalising ancient insights by experimenting on impressionable fee-paying students passing through US universities. For example, when Ariely proudly demonstrates how male students lose their moral compass while sexually aroused, by lending them pornography-loaded laptops coated in clingfilm (don’t ask), do we really learn anything new?

These quibbles aside, there is a more fundamental question raised by both books. Their positive message depends on the ability of Spock-like experts to identify rational choices amid uncertainty, so that they can nudge us Homer Simpsons into doing the right thing. But how capable are these experts at correctly identifying these choices, and can we count on them to speak up and protect us from powerful rent-seeking interests?

In the world of finance, the bubble-pricking track record of central bankers such as the Federal Reserve and the Bank of England is not stellar in this regard. This question is particularly apposite when considering the desirability of systemic financial risk regulation and its simpler alternatives. While that topic lies well beyond the scope considered either by Sunstein and Thaler or Ariely, it is worth bearing in mind. Once we take their uplifting prescriptions with the necessary grain of salt, we are left with two thought-provoking and well-written books.

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