The Cognitive Microfoundations Project: a behavioural economics world tour

There has been much talk about microfoundations on the economics blogs in the last few months [Noahpinion, Mark Thoma, Simon Wren-Lewis twice, Andrew Gelman twice, Karl Smith, Paul Krugman twice, Robert Waldmann, Rajiv Sethi from 2009]. The idea of microfoundations is that a model of the overall economy should be consistent with how individual people act. The aggregate behaviour of variables like GDP, government deficits and unemployment should be derived by adding up the choices of individuals, not by treating the whole population as if it were a single entity.

(A microfounded model might start off like this: "Imagine N agents, each of which has income y_n, consumes c_n and saves s_n. Then y_n = c_n + s_n. For each agent, s_n varies with the interest rate r according to the following relation..." while a non-microfounded model is more likely to start: "Total spending in the economy is C and saving is S. C+S must sum to Y, total income. S varies with the interest rate r...")

But does the microfoundations approach really work? It seems a good idea in principle. It works well in some other fields like physics and chemistry (though less so in biology). Building things from the ground up protects us against falling into certain mathematical traps. Some concepts (like the idea of people trading different goods with each other) don't really even exist at the aggregate level, so are hard to talk about without microfoundations. The idea that we can understand things in this level of detail is an appealing one.

Unfortunately, the idea of microfoundations has come to be closely associated with rational agent theory. Most microfounded economic models are implementations of DSGE (dynamic stochastic general equilibrium), which assume a population of rational utility-maximising agents who are given certain preferences and resources and respond logically to those. Readers of this blog, or of any behavioural economics book, will be unsurprised to hear that real people do not maximise utility in the way DSGE models insist - as demonstrated in numerous psychology experiments. Economists usually respond to this objection in one of two ways, neither of them quite satisfactory.

Response one: to claim that rational utility maximisation is close enough to the truth to describe the economy reasonably well. Sure, there are exceptions: people might not always discount future earnings in a consistent way, and sometimes we buy things because they’re on sale and not because our utility from the product exceeds the price paid - but those are minor errors, they mostly cancel each other out, we learn to be more rational over time, and the limits imposed by our income force us to act fairly rationally. So, DSGE models, maybe with a couple of small tweaks, are still the best way to describe the economy and work out how to manage it. We can still make inferences about how tax rates will change the choices of individual workers, or how interest rates will affect investment and savings decisions, and draw conclusions from that about how the whole economy will evolve.

Response two: to agree that individual rational agent models are too far from the truth to be useful but then to give up. For many, the failures of economic forecasting in the leadup to the 2008 crisis prove this. There are better ways to describe individual decisions - behavioural economics gives us some hints - but these are mathematically too hard to build models with. Therefore we shouldn’t bother with microfoundations - instead, we should reason from aggregates, such as the total amount of money, production, employment and debt in the economy. It is possible to work out, for example, that if companies try to save more money (as we can see they currently are), individuals try to pay off their debts (as they are), and governments try to cut their deficits (as they say they are) something must give. The model may not tell you which one will fail, but it can tell you that something must. These models can’t describe all economic phenomena because the aggregates don’t always tell you enough, but maybe they are all we have.

The first response is wishful thinking. The second is fatalism.

What if there is another way? Maybe, by choosing the right models from cognitive psychology and behavioural economics, and aggregating them in the right way, we can develop an accurate representation of large-scale systems after all. Then perhaps we can get the benefits of a microfounded model - which lets us understand many different economic phenomena, and gives us confidence via experiments that its conclusions are sound - but with greater accuracy, predictive power and robustness than today’s DSGE models.

Such models, microfounded not on rational utility theory but on real cognitive processes, might focus on specific domains such as consumer product markets or labour markets. They might let us explore the effects of specific economic policies such as tax or interest rate decisions. Eventually, they might develop into a unified theory that can be used to investigate any aspect of the economy - the cognitively sound equivalent of Arrow-Debreu general equilibrium theory.

Can this be done? It’s too early to say for sure, but it’s one of the most important questions for the economics discipline to ask itself.

So this year I’m going on tour. I will travel to wherever I can meet researchers in different economic domains and work out with them how psychology can be incorporated into their models. Although it might be possible to work out cognitive microfoundations from first principles, I suspect it will be more practical to start asking what kind of foundations will illuminate each different economic domain.

My initial objective is to work with people in each of the following disciplines:

• Consumer behaviour
• Competition and market organisation
• Labour economics
• Trade and international economics
• Fiscal policy
• Development economics
• Monetary theory
• Industrial organisation
• Personal finance
• Financial markets and asset pricing
• Environmental economics
• Health economics

I have a few collaborations lined up already, but there’s no restriction to just one in each field. So if you work in one of those areas - or would like to propose another - get in touch and I can add your location to my itinerary.

So far I’ve been to Madrid, Barcelona, Marseille, Paris and Honolulu. From today, my immediate plans are:

• Until 13th June: San Francisco and Berkeley.
• 13th-19th June: Atlanta.
• 19th-30th June: the northeastern US - DC, NYC and all points between.
• July: the UK and South Africa.

If you’re near any of those locations why don’t we meet up? If we discover anything useful there’s a co-author credit in it for you.

Did he jump or was he pushed; is there a difference?

This New Yorker article about why so many Americans are single reminded me of the debate about unemployment prompted by Casey Mulligan. Here’s why:

From the New Yorker: "...do people live alone because they want to or because they have to?"

Paraphrasing Mulligan and his critics: “Are workers choosing to be unemployed or are they forced to be?”

[actual quotes from Mulligan: "there are sensible people...who will recognize that 2009 is not the time for them to...commute a long distance to work...[unemployment insurance has] dramatically reduced the costs to them of making this the year they coach junior's baseball team, or do some work on their house, or spend time with an ailing parent" "the market tends to create and allocate jobs for those people who are most interested in working" and "my research has been to examine...changes in the willingness and availability of people to work" versus Dean Baker's "this does not mean that less-educated workers could find jobs if they really want them"]

Both quotes reveal a simplistic view of the nature of choice. It’s as if our choices are fixed – and we will always make the same choice unless there is some barrier in the way. The New Yorker assumes that each of us either definitively wants to be single or wants to be married, and that we’ll get our way unless something thwarts us. The debate over Mulligan's claims, on the other hand, take literally the fact that we have free will – so if someone laid off from a Detroit factory or a Texas high school has chosen not to take the minimum wage job at Walmart, their unemployment is voluntary.

Mulligan’s view is often mocked – Ryan Avent calls it “The Great Vacation” (did he coin the phrase?) – but it does at least have some internal consistency. People intuitively object to this story because it seems to imply people’s preferences have changed, and they have just decided they now want more leisure. But in fact this model assumes that preferences are exactly the same, and it’s the available options that are different. Simon Wren-Lewis writes here:

"In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time"

One defence of Mulligan is to read his claim more narrowly: that unemployment benefit reduces people's desire to work by a bit, increasing unemployment by an unknown amount - which seems plausible - and not that the whole recession arises from this cause.

Regardless, the right approach to both claims - that unemployment is voluntary or that Americans are forced to be single - is that people's actions are a result of both our individual wants and the environment we find ourselves in. Our wants might indeed change over time – though this tends to be a slow process. Our choices change much more quickly, because the same person in a different environment will make a different choice from the same options. A man with £10 in McDonald’s may choose to eat, while a man with £10 in Gordon Ramsay’s may choose not to eat (even though technically he could buy something from the lunch menu). The man is the same, and his budget is the same, but his actions are different.

Even the idea of “the same options” is dubious. Has the man in Gordon Ramsay’s really been offered “the same options” as the man in McDonald’s? Is a worker turning down a cashier job in Walmart choose from “the same options” as a worker taking a project management job at Boeing? Economics is partly about abstracting away the differences between different situations, but we must recognise when we’re abstracting too much.

Standard economics takes us up to about this point, and Noah Smith says as much in this post. Each person has preferences which determine the relative exchanges they’re willing to make. These preferences define a particular value for my time – £20/hour – so that if the wage offered (adjusted a little to take account of employment terms, location etc) is greater than £20/hour, I’ll take the job; otherwise I’ll stay at home. Similarly, my preferences may determine that the effort and sacrifice of being in a couple has a certain cost to me, and only if the benefits outweigh that cost will I enter a relationship. Thus, I may be more willing to go into a relationship with a person who I find more attractive (thus increasing the benefit of the relationship) or if housing prices rise (increasing the cost of staying single).

The psychology of decision-making says things aren’t this simple. The factors that determine the cost and benefit of each option are not stable. My preferences fluctuate according to how I feel, and my perception of the options I’m choosing between will change according to what I’m thinking of, what I’ve been reminded of, and what I’m looking at. Some factors become more important because they are more salient, and others may be ignored altogether.

Some particular factors become important to me which, according to a rational utility model of choice, should not matter at all. For instance, the wage I was paid last month should not be relevant to whether I accept a job at Walmart this month. But you can be sure it will be. There are a whole range of possible reasons for this: I may have mortgages and bills to pay that require me to earn over a certain level; I may treat my last wage as a signal of what I’m likely to be able to earn if I hold out for a better job offer; or I might simply feel ashamed to accept a 50% cut in pay. Whatever the reason, either my preferences, or my beliefs about the context I’m in, or both, are now seen to be dynamic and not static.

This means it is too simple to say “my preferences have changed” or even “the environment has changed”. Both are always changing. My choices are constructed in each moment out of the information available to me from inside and outside my mind.

There is not even a clear distinction between preferences and context. My preference to work at £21/hour instead of staying at home is in turn influenced by the context I live in, in particular the level of my mortgage payments or whether I think the economy is getting better. So the choice is in fact a tradeoff between one external factor (the job offer) and a series of others (mortgage, economy) with my mind as the calculating device that sits in between, weighing up the factors.

My mind of course is not perfect, and it can only roughly estimate the strength and future path of each factor. So it relies (I rely) on rules of thumb, heuristics, to save time and make it possible in practice to actually make any decisions at all. Those heuristics themselves can change over time, as I have new experiences which I learn from – and which may invalidate old heuristics or lead to new ones. Maybe the last time I took a low-paying job, in high school, my brother got a better one the following week, and laughed at me. The heuristic that I might learn from that is fairly clear, even if I’m not conscious of it when I make my decision now. If I turn down this job and don’t get another offer for three months, perhaps my heuristic will change.

Can we even distinguish between heuristics, preferences and environment? Not clearly. From the outside we cannot tell whether the man turning down the Walmart job is doing so because he has a clear, conscious preference for a £20/hour job, or whether he’s subconsciously applying a rule of thumb his brother taught him by teasing 20 years ago, or whether he simply cannot afford to work for less because it won’t pay the mortgage and he has to hope for a better offer next week. Even internally, the man himself probably does not clearly know the difference between these three causes. So is it meaningful to say that they are three distinct phenomena?

We haven’t even discussed the signalling and cultural implications of taking a job at Walmart, or the influence of the way in which the offer is communicated (“We’d really appreciate if you’d take this job, to help us to serve your community better” or “Head Office has approved your application for employment, and subject to security and identity checks you may arrive on Monday at 8am sharp.”). Language and culture too shape our interpretation of the choices we are offered and the factors that we take into account; this can be seen as part of the cognitive process or as part of the environment in which we choose.

We are left with two ways to think about choice. The first option is to declare the process of choosing to be too complex for simple interpretations like “unemployment is voluntary” or “Americans are single because they have no choice” to be entirely true (or entirely false). The second option we can find a new and more accurate abstraction to describe choice – I like to think of it as “a cognitive algorithm which translates external and internal signals into actions”. In this view, the idea of voluntary unemployment or involuntary singledom simply lose their meaning. The very term voluntary becomes moot.

Then, did the unemployed man jump or was he pushed? All we can say is that a confluence of factors - physical, or emotional - and his response to them, caused his fall.

Where, then, has free will gone? Was it ever there in the first place? That must wait for another post.

Behavioural economics: the Kylie Minogue of market research

Do you remember those catchy tunes from the late 1980s? I Should Be So Lucky? The Locomotion?

The first time you heard them they were quite fun, memorable even. But then they got more airplay. And more. And more. Radio stations figured out that the sugary, bubbly popness of the tunes would cut through a lot of background noise and get your attention, so they played them again and again. Soon we had Got To Be Certain, and Je Ne Sais Pas Pourquoi, which were exactly the same as the first two songs. Then a "strategic inter-agency collaboration" with Jason Donovan on Especially For You. (Jason looks a bit less lifelike in this alternative version).

After a short interlude in late 1989, another number 1 with Tears On My Pillow, which was meant to be more sophisticated but was equally artificial, overproduced and in fact just the same old song as I Should Be So Lucky. By this time anyone who wasn't a 13-year-old girl was thoroughly sick of Miss Minogue, who wasn't even on Neighbours any more. Interest and record sales rapidly declined, and thankfully Nirvana showed up to distract us.

 On a completely unrelated subject, do you remember those talks about behavioural economics that infected the market research industry in 2009? Someone had read Nudge, and someone else got a copy of Predictably Irrational. It's quite easy to write a behavioural economics talk - you just claim that everyone else in the world thinks people are irrational, but you have spotted (with the help of Daniel Kahneman perhaps) that they're not. Read out a list of cognitive biases - anchoring, hyperbolic discounting, social norms. Show some slides with illustrated examples of each bias. If you're brave, test one of them on your audience and hope they haven't yet been to enough identical talks to see through your ultimatum game or your auction. I am just as guilty of this as anyone else.

As straightforward as this formula is, it's no surprise that throughout 2010 and 2011 you've had the opportunity to attend perhaps twenty workshops, panel discussions and seminars every year containing exactly the same content. Every Market Research Society conference since 2009 has had a behavioural economics session. Every agency has sent one director and two junior researchers to a training course. Every agency at the top of the GRIT rankings has a behavioural economics link on its website or its case study at ESOMAR.

(Don't get me started on fecking neuromarketing.)

The backlash was smooth, professional and equally predictable. "But isn't behavioural economics just what good marketers have been doing all along? This theory is all very well, but how do we use it? Cognitive biases are all very well in the lab, but how do you know the results apply to consumers in the real world? Anyway, it's all just a fad."

Put any three market researchers in a pub and mention behavioural economics, and I guarantee the conversation will proceed swiftly along the above lines.

But wait one second.

It's 2000. Kylie hasn't had a number 1 single for ten years, or even a top ten hit since 1994. She's a joke. She's been dropped by her record label. There isn't even a nostalgia industry around her yet. In fact, Nicole Kidman's the only Australian we recognise now.

Paula Abdul writes a song but decides not to record it. It is hawked around the industry and eventually gets passed on to Kylie.

Spinning Around is a worldwide hit, number 1 in the UK and Australia, and revolutionises Kylie's career. The theme of the song reflects Kylie's own transition: she's grown up. No more novelty singles or soap opera posing. She's sexy now.

Behavioural economics is ready to grow up too. Enough with the cognitive biases, the party tricks. The field is actually based on much deeper psychological research into judgement and decision-making, cognitive theory and information processing. It's time to abandon the false tension between "rationality" and "irrationality". Our minds process information and choose actions in a way that is locally rational. But when viewed globally, these choices show that there are conflicts between the different interests and needs that a single human being has.

Behavioural economics, and the cognitive theories that underpin it, gives us insight into how people interpret the world, what people want, and the actions people take in response. It invalidates traditional methods of market research and marketing cliches - but only once it is taken seriously. It tosses out the basis of conventional economics, consumer preferences - and the very notion that we make "decisions" between "products".

There is a proper, integrated theory here, based on the idea that people adapt to a basic level of satisfaction, and act to restore it when it is disturbed. They rely on efficient but imperfect memory to retrieve a variety of strategies to restore that homeostatic equilibrium, and only when those strategies lead them towards product acquisition do they apply something a little bit like a standard consumer choice process - but one constrained by the brain's information processing limits. Experimental psychologists can help you design experiments to measure each of these stages, and you can design interventions to change the behavioura of the average consumer at each point.

Yet we only have access to these insights once we stop playing at party tricks; stop pretending that people are really rational except when we pull the wool over their eyes with a clever heuristic. Only when we use a well-founded model of cognition and design our research methods to uncover its parameters, will we be able to predict, and more importantly influence, what consumers do.

Behavioural economics has a new record company, and it's about ready for its serious phase. Time to reinvent it. That complex, but scientifically measurable, cognitive model is what runs your mind, and you can't get it out of your head.

Clearing my tabs for 2012

During 2011 I have probably spent about four days waiting for my browser to respond, due to the number of tabs I habitually keep open. Between the four computers I use, I probably have 200 blog posts in tabs waiting for me to comment. Here are a few of them (in no particular order), so my Chrome may enjoy a faster 2012.

1. A note from Paul Krugman on what makes economics economics. Not a rhetorical discipline but one based on mathematical models. (However, see also Deirdre McCloskey's Knowledge and Persuasion in Economics, which puts forth a persuasive case that it is both. Also, I believe that rhetoric, culture and all forms of speech will one day themselves be modelled within economics - a tantalising prospect).
    
2. Talking of persuasion, here is Steve Randy Waldman on market monetarism, and whether we can fix recessions by simply persuading people to change their economic expectations, or whether there are real constraints that can't be solved just by monetary easing. I could plausibly have picked any article on his interfluidity blog as article of the year (if I were doing an article of the year), but this quote alone shows more insight than most entire blogs: "Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief Paul Volcker Chuck Norris moment but for the indefinite future."
    
3. A good overview of Daniel Kahneman's life and work, including the origins of behavioural economics and how Kahneman and Tversky's work has influenced other fields.
    
4. The limits of the scientific method in economics (see also part two): an article whose conclusions I don't agree with, but which asks the right question: can economics model (and predict) the behaviour of people whose behaviour is itself influenced by economics? In answer, Roger Martin claims that we can't use deduction or induction to predict the future, only to model the past; to look forward we must use "abduction", or "invent a new hypothesis". This seems a very nihilistic, not to mention impractical, view. He too calls on rhetoric and postmodernism, but unlike McCloskey, who analyses what those things actually consist of, Martin simply attempts to use them as a get-out clause from the anti-scientific logic of his argument.
    
5. Mark Thoma's more economics-friendly response to the above. His response to Martin's question, pointing out how the field of rational expectations was invented to answer it, and defending economists' work in coming up with new models as the old ones are proved wrong, is much more to my liking.
    
6. An article from the Economist's Blighty blog about behavioural economics - or, more precisely, behavioural social policy and behavioural politics. Despite co-opting Nassim Nicholas Taleb as a behavioural economist - believe me, we don't want him - this piece has some good insights into psychology and why so-called "irrationality" (let's call it "fast heuristics" instead, shall we?) isn't always a bad thing.
    
7. Also from Mark Thoma, a quote from Keynes to the effect that society can only build railways and other bits of infrastructure when it participates in a shared illusion that enables it to invest, not consume, the fruits of its wealth.
    
8. Why values, as well as resources and incentives, are important in economics. As usual, a thoughtful essay by Tyler Cowen, one of the most open-minded writers on the right. I hasten to add that this degree of open-mindedness is also rather hard to find on the left.
    
9. Some excerpts and a review in the New York Review of Books by John Lanchester of Michael Lewis's Boomerang, including possibly the quote of the year: "you have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners but Icelandic banks, with a billion dollars in new assets". I haven't yet read the book itself, but I'm interested in its attempts to explain economic differences - and similarities - by reference to local culture. As Lanchester says, "The collective momentum of a culture is, for more or less everybody more or less all of the time, overwhelming. This is especially true for anything to do with economics". He draws a broadly downbeat conclusion, but I believe the real need - and opportunity - is to analyse what culture is and how it affects economic behaviour - at which point we might be able to figure out what to do about it.
    
10. See if you can boil this FT article about crowds, behavioural economics and neuroscience into nine insightful, factual sentences while ignoring the rest of the silly oversimplifications.

 

Of course, the time I've spent writing this article far outweighs any browser speedup I am likely to earn over the next twelve months - especially taking into account the forty further tabs I will undoubtedly open over the next week. But I hope you've found the links useful in helping waste some of your own valuable time.

What is "playing"?

In between work on some more serious posts (not to mention the day job), let me post a brief comment on Margaret Robertson's article on gamification, "Can't play, won't play". It was written a year ago, so I'm not expecting to provoke an intense debate, but the same argument could easily be made today and it's worth responding to.

In short, Margaret claims:

gamification isn’t gamification at all. What we’re currently terming gamification is in fact the process of taking the thing that is least essential to games and representing it as the core of the experience. Points and badges have no closer a relationship to games than they do to websites and fitness apps and loyalty cards.

Her preferred vision of games is:

Games manage to produce [rich cognitive, emotional and social] drivers by being complex, responsive mechanisms. Games set their players goals and then make attaining those goals interestingly hard.

My involvement and interest in games is much shallower than Margaret's. She's a leading game designer and spends (I imagine) much of her life either playing or creating games. My interest in games is a psychological one - for me, they are a simplified, purified version of the motivations that drive us in real life. They provide a simple domain in which we can either examine, or manipulate and take advantage of, those motivations.

Undoubtedly Margaret, and the millions of other people who have a sophisticated and detailed experience of many different games, would be unsatisfied with the simple games that might keep me happy. Similarly, a novel which entertains an occasional reader may not provide meaning or interest to a literature graduate. But it doesn't mean it isn't a novel.

Margaret doesn't agree. She says:

...there is no way, not one single way, in which [Nike+] is a game.

Her distinction is between "gamification" (creating meaningful choices, which change the way you experience the game or the world) and "pointsification" (adding quantitative measures which simply count up your achievements). But I don't see why this is a category distinction - rather, it is a matter of degree. There are simple games - like Nike+, which helps you measure your progress as you run further and faster each day - and complex, subtle games like, I don't know, Portal or World of Warcraft. They can both provide meaning if the player invests it into them; or they can both be mechanistic, boring processes if you're not engaged.

Perhaps Margaret sees no meaning in the distinction between running 1k and running 5k in Nike+ - but I certainly did, when I "played" it. I was pretty damn proud to get through the 3k and 5k barriers, having started running for the first time a couple of weeks before - and the transformational experience when I first realised I was not forcing my legs to move, but was enjoying running for its own sake, was packed full of genuine meaning. And it would not have happened without Nike+.

So, no doubt advanced gamers have higher standards. They are no longer satisfied with what entertains us neophytes, and they need more advanced games to engage them and provide meaning. But this doesn't mean the games that entertain me aren't still games. My simple points-based achievements fulfil the same psychological role for me as those meaning-laden choices and consequences do for an experienced game consumer. There are degrees of meaning.

I suspect it's easy for an advanced consumer of any art form to forget the simple pleasures that inexperienced consumers get. Once you've seen The Wire it's easy to dismiss Cagney & Lacey. When you learn the subtleties of Beethoven you may not think the Spice Girls are real music any more. If you have translated Beowulf into modern English, the crudeness of Dan Brown is ruthlessly exposed. But the commuter who enjoys Dan Brown on the tube will be left equally cold by Beowulf, until they've learned how to appreciate it.

Games are no different. Until you've invested enough playtime to become familiar with the distinctions offered by the subtler choices and more complex consequences of Minecraft or Skyrim, points, levels and badges still provide a sense of achievement and, yes, meaning, that can be psychologically very powerful.

A thought experiment: why the ECB should print money...

...and why the Bank of England and Fed are right to have done so already.

I'm not talking about whether the European Central Bank should directly buy eurozone government bonds. This causes a moral hazard problem - it might encourage governments to be profligate and reduce incentives for structural reform. It's, at the very least, debatable. I'm talking about a more general question: why should central banks print money in a recession?

This post won't have much new to say to macroeconomists, but it attempts to address a concern of many non-economists - won't printing money just cause more inflation?

First, let's run a thought experiment. Imagine that your national government has decided that profligate use of fossil fuels is a problem. Probably because of the risk of climate change. Instead of using a carbon tax, the government decides to restrict the supply of oil coming into the country. It could allow more oil in if necessary - in fact it has a large reserve stored up for emergencies - but it chooses to limit how much oil its citizens use, by keeping the supply at the level which corresponds to a sustainable quantity of carbon emissions. Aside from this intervention, it lets the market set prices and doesn't regulate who uses the oil or what for.

Over time, people come to know what the supply of oil is going to be each day, and they know how much they use, so prices adjust to the level that balances supply and demand. Most people have a certain "stock" of oil - petrol in their car, oil in their heating tanks, or - for electricity generators - a reserve of oil to run their power stations for a certain number of days.

Suddenly there is a disruption to oil supply. Maybe terrorists start attacking oil pipelines and people start to get very worried about whether they will still be able to get petrol. Perhaps a couple of refineries break down and there's a global shortage of refining capacity. Maybe a couple of petrol tankers explode, and 80% of tankers are taken off the roads for a few months until they can be fitted with new safety equipment. What happens now?

The first thing is, people's demand to hold spare oil reserves will go up. They are aware of the supply risks, and the disruptions to the oil distribution system makes them worry that they won't be able to get petrol when they want it. So people start to hoard oil and petrol. Maybe there are knock-on effects - petrol stations can't get the petrol they need to sell, and some of them might become bankrupt. Probably, the price of petrol would soar. Electricity companies will, if they can, increase prices or reduce the amount of power generated so that they in turn can build up their inventories. Note that all this may happen even if the supply problem is more feared than real.

People try to buy extra petrol to build up a reserve, while still maintaining their normal lifestyle - but they can't, because there's only so much petrol to go around. So there are shortages at the pump - which of course receive national news coverage. The next day, everyone else shows up to fill their tanks - the gas stations run out within a few hours - and the problem gets worse and worse.

Everyone is trying to hoard petrol just in case the next person gets in and hoards it first. Of course oil prices might eventually stimulate new distribution channels or new sources of production, but it will take a while. In the meantime, the economy is seriously disrupted because everyone is forced to use less oil and petrol than they are used to, and the country will probably quickly enter a recession, with high unemployment, reduced GDP - and government deficits following automatically.


What should policymakers do (if anything)?

Even though the government still regards climate change as a serious risk (and let's say voters agree with this concern), there's a paradox: demand is up but petrol usage is down. All the extra demand is for reserves, not petrol usage.


I say the government should gradually release its reserves into the market. This will let people build up their stocks of oil and petrol to whatever level they are comfortable with, and usage will go back to normal. Once this happens, the government can stop releasing the reserves and a new equilibrium will be reached. Petrol stations will get back to roughly the level of sales they had before, electricity companies will get the reserves they need and start generating power at normal levels again.

The story is: a demand has arisen for people to hold more petrol stocks, but not to burn more petrol. The government is the regulator of petrol supply, and has a reserve, so it can open the taps and let people have the stocks they want, without causing any more carbon emissions. Then, if people's worries about supply reduce over time, they will run down the spare petrol stocks, and the government can restrict national supply a little more to balance this out and build up its reserves again.

To get the timing and the supply just right, the government will have to keep a close eye on petrol prices, but that isn't too difficult to do - the market signals are all available. Opening the reserves seems an obvious solution with no real downside.

Now you may have figured out where I'm going with this. In this story, replace "oil" and "petrol" with "money", "national oil reserve" with "central bank printing press" and "carbon emissions" with "inflation". Now we have the story of the financial crisis and the recession.

The government (via the central bank) in normal times deliberately restricts the supply of money to keep inflation under control (interest rates are just another way of doing this). They have a reserve - they can in fact print as much money as they want - but they choose not to use it, because that's their way of managing inflation and maintaining the value of their currency.

When the credit crunch happened in 2007-08 - a couple of banks went bust, so people naturally became concerned that the supply of money and loans was going to shrink. Everyone wanted to hang onto more money, just in case. Banks stopped lending to each other in order to keep more of their money in reserve - and because they were worried that the other banks couldn't repay them. People cut back on spending not because they didn't want as much stuff any more, but in order to keep some spare cash just in case they lost their jobs. And of course, these actions feed off each other - when the whole population cuts spending, people do lose their jobs. When all banks stop lending to each other, they don't end up with more money - they end up with less.

We have a situation where there is high demand for money - not because people want to spend more, but because they want to save more. To stop this from causing a recession, the central bank has to "open the taps" - by printing more money. Normally this would be the equivalent of cutting interest rates - but when interest rates get to zero, it needs to be done in other was.

This will not cause inflation if they only release just enough new money to let people increase their reserves to their new "safety level". And later, when people are reassured and don't need to hold as much spare cash any more, the central bank can reduce the money supply again and/or increase interest rates to soak up the money back into the reserve.

Just as with the oil reserve, there are different ways of doing this. The government could give out petrol directly to individual households. Or it could sell it to the oil companies (at market prices) and let them sell it on - this would probably result in it going more accurately to where it's needed, but the oil companies would make a profit too, so it might not be politically popular. No doubt you can see the parallel again - some people would like the central bank to just give money directly to citizens, but instead they normally do this by "selling" money to banks (by buying government bonds from the banks) and let the banks lend it out, again making a profit. This is a more economically sound way of getting the money to where it's needed, but the banks will make a profit on it - because distributing money is, after all, their business.

If the political situation calls for it, perhaps the government will impose a windfall tax on the oil companies/banks to compensate for the extra profits they are deemed to have made while helping to solve the problem.

It turns out the Federal Reserve, Bank of England and Bank of Japan have been doing just this throughout the last few years. While it hasn't resulted in those economies returning to full health, it has probably helped stop them going back into recession. Many economists think they just haven't released enough reserves, and should do a bit more; though there is also an argument that some of the economic slowdown would have happened anyway, while the economy rebalances away from housing and finance, towards other industries.

The one major central bank that has not done it is the European Central Bank. They have cut interest rates - though probably not enough - and loaned a bit of extra money to some of the banks to tide them over (imagine giving the petrol companies enough extra reserves to help them stock up their spare petrol tankers, but not enough to satisfy the demands of the population itself).

And now there's a new twist: imagine that eurozone governments themselves use a lot of oil (money), and now they can't get enough petrol (money) to fuel their own operations. With petrol (money) prices soaring, some of them have used up their internal reserves and may have to shut down some of their operations. This in turn would cause more problems for the economy, making things even worse for the citizens who are short of both oil (money) and the government support they partly rely on.

The ECB's job now is to open the reserves. An infusion of money into the Eurozone would help cure the capital problem that the private banks are suffering from, restoring economic growth and automatically improving the financial position of Eurozone governments. It would help prevent or soften the recession that is currently expected in Europe, making it more likely that Italy, Spain and Greece will be able to finance or refinance their debts, which in turn will let them borrow at more reasonable rates.

The ECB does not need to buy the bonds of those countries directly, if it is concerned about setting a bad precedent - just as the oil reserve would not need to be issued on credit to unstable petrol companies. Just increasing the supply to the good companies (good banks, creditworthy eurozone countries) will have a knock-on effect on the others.

Because the problem has been allowed to get this bad, there is now a risk that the money (petrol) will not get to where it is most needed. To help fix this, other steps might be needed. In the petrol scenario, the government might part-nationalise some of the weaker petrol companies, or subsidise investment in new pipelines to make sure the petrol gets to all parts of the country. In the Eurozone, some big capital investment programmes in southern Europe might be a better way to distribute money than simply giving it directly to the Italian, Portuguese or Greek governments. But these are less important than the emergency response.

It's time to open the taps - or as Doug Saunders put it the other day: Mr Draghi: TURN ON THAT PRINTING PRESS!

Does Nudge require regulators to be "more rational" than consumers?

A couple of times recently - notably in Bill Easterly's otherwise very positive review of Daniel Kahneman's new book - I've seen the following common critique of Nudge-style approaches: "But if people are irrational, regulators are irrational too - so how can they make rules to counter citizens' irrationality?" Easterly says:

But [the case for libertarian paternalism] is much too sweeping, because it overlooks everything the rest of the book says about how the experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making...

While it's right for regulators to be humble about their degree of knowledge about the world, and to be cautious in creating new regulations, there are several reasons why this particular criticism is wrong.

First, we are not comparing like with like. There is no claim that a regulator, when placed in the same situation and making the same decision as a citizen, will come up with a better answer. Instead, we are looking at times when citizens make snap decisions without thinking them through - or, often, make no overt decision at all because they do not notice that there is a decision to be made. In these cases, the regulator's goal is either to say "what would the citizen decide if they did think about it carefully?", or even better, to encourage the citizen to make the effort of thinking it through themselves. If the answer to "what would the citizen decide?" is controversial or ambiguous, the regulator is unlikely to try to intervene.

Second, everyone specialises in something. A lawyer specialises in the law - I wouldn't expect them to be better at making business decisions than me, but where my business decisions have legal ramifications I'd like to have their input. A doctor does not know better than me what I should choose to eat for dinner, but they can give me useful information to help me pick the foods that are right for me. And similarly, somebody who spends their professional life thinking about decision-making and examining the extensive research in this field is likely to be able to help me make decisions that I'll be happier with.

Third, even if regulators are not perfect, a best-effort regulation may well be better than none at all. The absence of regulation does not mean the absence of nudging. As Thaler and Sunstein point out in Nudge, our decisions are going to be influenced by context, framing and defaults no matter what. If the government takes no part, then the influences will be random, or chosen by private companies (whose interests are sometimes opposed to mine, though not always). If a democratically accountable government can help to move from one default frame to another that is more likely to be in my interest, then why would I not prefer that one?

There are people who read public choice theory as implying that most government policies are likely to be corrupt and wrong-headed. These people may well oppose Nudge-style regulations as they oppose most other regulations. But I think that view is not a mainstream one.

Indeed, mainstream economics has a clear place for regulations - where the action of a private party imposes an unpriced cost or "externality" on others, an appropriate regulation will actually make the market function more like a genuine free market, not less. One could argue that the framing carried out by private companies acts as an externality by imposing hidden costs on the consumer - in which case a better market outcome will be achieved by reversing these frames.

Finally, Nudge policies are designed to be optional. Anyone who does not trust government to provide a default which is in her own interest is welcome to ignore the government's recommendation and make her own choice. Those who would prefer to make the tradeoff of trusting the government's (carefully researched, democratically supervised) recommendations can simply take the default and save themselves the effort of thinking it through, and reduce their risk of making a mistake.

Easterly certainly raises an interesting challenge for behavioural research: the "system-wide effects of paternalistic policy-making" are indeed not well-understood. The fact that the policies are optional for the citizen is (I suspect) likely to mean that the system exhibits stability rather than instability, with any effects of Nudge regulations being damped rather than amplified by the interactions of the system. But it's not certain yet. My own research focuses partly on this area, as I think it's important to find out how a more accurate picture of human behaviour, scaled up to the systemic level, will affect our understanding of how markets work.

I notice that I have written on this subject before, so I'll finish by quoting myself:

We don't expect aeronautical engineers to be immune from the law of gravity. Yet we still trust them to design planes that can help us transcend our own gravitational problems.