I try to teach people to make fewer mistakes,” said the newly-minted economics Nobel laureate, Richard Thaler, in an interview earlier this week. “We need to take full account of the fact that people are busy, they’re absent-minded, they’re lazy.”
Congratulations to Professor Thaler; I think his brilliantly accessible work is part of a growing and important contribution of behavioural perspectives that enrich traditionally strictly “rationalist” economics. I just wish the laureate had avoided making some big mistakes of his own, where he failed to apply his theories to himself. After the November 8 demonetisation in India, he had tweeted, “This is a policy I have long supported. First step toward cashless and good start on reducing corruption.”
Wiping out 86 per cent of a country’s currency is rarely a “good start” on anything. In a country where, according to recent analyses of income-tax probes, the cash component of undeclared wealth is estimated to be only about six per cent, leaving an economy virtually cashless is certainly not a good place to end up. If Thaler had studied the data on the Indian economy he might have realised that the policy instrument he had supported was aimed at the wrong target: The currency of corruption is mostly in non-cash assets.
I also find it ironic that Thaler, an expert in behavioural economics, did not account for the proposition that people have a strong incentive to not lose money. In other words, they will seek out ways to deposit their invalidated cash in the banks. Thaler should have anticipated that Indian society — not unlike societies around the world — has access to money-laundering networks and creative schemes for getting around rules. And people will use them — it’s the only consistent thing for a behavioural economist to anticipate. No wonder, the RBI recently reported that of the estimated Rs 15.28 trillion ($239 billion) in currency taken out of circulation by demonetisation, almost 99 per cent had been returned.
On the other hand, the intricacies of the Indian context may have been a bit too distant and Thaler was probably busy, just as he had predicted that people generally are. He didn’t have a chance to check the data before he tweeted. The moral: Even Nobel economists make ignoble mistakes about economics. This is true even if they are in the business of teaching people to make fewer mistakes.
To give Thaler his due, Nobel economists have a particularly hazardous job. Like all economists, their tradecraft is the study of social science. They must operate within the boundaries of a paradigm or a model, founded on several assumptions to explain and predict complex phenomena at individual and societal levels. Even when the model is validated by data, the complex drivers of human behaviour, psychological factors, incompleteness of information and systemic market factors can make the best economists spectacularly wrong. For the Nobelists, the challenge is that their every utterance gets amplified and every decision they make is seen as flowing from some profound application of their own models. This, of course, sets them up for potentially finding themselves on the wrong side of history.
The great Paul Samuelson had predicted that Soviet GNP would exceed that of the US. He was convinced that “contrary to what many sceptics had earlier believed, a socialist command economy can function and even thrive”. He persisted in making the prediction in successive editions of his widely read textbook and kept changing the dates when this infamous GNP crossover might happen. It took the fall of the Berlin Wall to convince the “father of modern economics” and the first American Nobel economist to give up.
Misreading the direction of great powers is, of course, not unique to Samuelson. Another legendary Nobel laureate, Ronald Coase, made the opposite mistake — of under-estimating China’s rise. China’s ascendance was clearly one of the most significant events of the modern global economy. But Coase had no inkling that it would happen this fast. “I thought it would take 100 years, if not more,” he said. He was, of course, a laureate in humility as well. “I’ve been wrong so often I don’t find it extraordinary at all,” he said when presented with the facts.
Surely, the moment that would cause humility to be tossed out the door was the global financial crisis of 2008, when far too many economists were caught napping. Nobel laureates, such as Paul Krugman, excoriated his colleagues, primarily those hewing to the Chicago School. “When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly,” he wrote in a scathing essay. “Economists as a group mistook beauty, clad in impressive-looking mathematics, for truth.” His wrath was aimed at fellow Nobelists, Milton Friedman, Eugene Fama, among others.
Of course, the opposite school was swift to point out Krugman’s foibles. John Cochrane, in a counter-strike, wrote: “I’m old enough to remember when Krugman was young, working out the interactions of game theory and increasing returns in international trade for which he won the Nobel Prize… He (Krugman) once wrote eloquently about how only math keeps your ideas straight in economics. How quickly time passes.” Krugman, of course, now spends most of his time as a liberal columnist; understandably, conservatives routinely list his mistakes, so much so that Krugman feels he must get ahead of his detractors by listing his own mistakes before they do. Examples of Krugman’s mea culpa: Missing the scale of the housing bubble, pre-2008 crash; over-estimating the risk of a Euro breakup; missing the possibility of persistent inflation.
For those economists and non-economists who suffer from an extreme case of schadenfreude, the most satisfying case must be that of Long-Term Capital Management, a hedge fund. Two of its founders, Myron Scholes and Robert Merton, did pioneering work on derivatives that won them a Nobel, but this work also yielded a trading strategy with a promise of untold millions. A year after the award, Long-Term Capital Management lost $4.6 billion and had to be bailed out.
Of course, several Nobel laureates have had their work severely critiqued — completely normal course of business in the gladiatorial ring of academia. Some faced especially intense opprobrium. Nobelist Bob Fogel, with Stan Engerman, concluded that American slavery was in fact both efficient and profitable. This finding was not just politically incorrect it was considered an unethical justification of slavery by many who criticised both the results and the methodologies. Fogel was, to be sure, no neophyte at unorthodox methodologies and results. Earlier he had taken the question of the impact of the railways on the American economy, and tested it using “counterfactual history”. He built a hypothetical network of canals and demonstrated that they could have substituted for railways; he concluded that railways could not be solely responsible for American prosperity. The approach was considered somewhere between absurd and a waste of time by critics.
Yet another Nobelist, James Buchanan, spread a political ideology of public choice theory that remains alive among the radical right and many extreme conservative and libertarian groups. The majority opinion, as revealed over multiple electoral cycles, may be that Buchananism is considered to be a tad too far to the right — and the wrong prescription for large complex economies. Buchanan, of course, would have seen this coming as he was convinced that the democratic majority can’t really be trusted and had advocated for the elevation of empowered minorities as the true guardians of liberty.
The Nobel committee probably sees mistakes to be par for the course in economics. In its infinite wisdom — or perhaps to teach us all a lesson not to take these seers to be perfectly clairvoyant — the committee jointly awarded the prize in 2013 to Robert Shiller, a behavioural finance guru and his intellectual opposite, the “efficient markets” theorist, Eugene Fama. Clearly, one of them would be given the prize for being wrong.
Thaler, the latest laureate, after his brief fascination with demonetisation, may just have exposed some charlatans, but these are the kind outside the Nobel family. When informed a few minutes after his laudatory tweet that the Indian government planned to issue a new Rs 2,000 banknote, he seemed to change his mind. He tweeted: “Really? Damn.”
All it took was a nudge.