Does Richard Thaler Deserve the Nobel Prize in Economics?

Economist Richard Thaler, whose known for work in the field of behavioral economics, was recently awarded the Nobel Prize in Economics.

Reuters reports:

Influential in the field of behavioral economics, his research showed how traits such as lack of self-control and fear of losing what you already have prompt decisions that may not have the best outcome in the longer term.

“I think the most important impact (of my research) is the recognition that economic agents are human and economic models have to incorporate that,” Thaler, a professor at the University of Chicago Booth School of Business, said in a call broadcast at the Nobel news conference.

Though many have applauded the choice of Thaler for the prestigious prize, not everyone  agrees that it was the right one.

Peter Foster has written an article for the Financial Post, making the case that the choice of the recipient should have been far more controversial than it was. He also suggests that Thaler’s contributions are devoid of any significant insights.

I believe Foster is partly right and wrong.

Foster writes:

Behavioural economics is rooted in claims that economics is weighed down — indeed fundamentally flawed — by naive belief in human rationality: that the house of economics is built on the sandman “homo economicus,” a profit-maximizing Vulcan. In fact, Thaler notes, humans are a mess of erroneous assumptions and inconsistent choices. He likens the average human to the hilariously incompetent Homer Simpson, calling him “Homer Economicus.”

But Thaler’s alleged insights are based on misunderstanding of economics, on trivial examples, and on a non sequitur. Economics is the study of human interaction in markets. It’s about what people do, not why they do it. Thaler’s non sequitur is: “because people are irrational, government is needed — and able — to help them make wise(r) decisions.”

Economists study how humans act to allocate resources in a world of scarcity. They study how humans act – understanding why they act in the way they do is normally an endeavor reserved for psychologists.

However, it’s also critical to understand that human action can be both rational and irrational. When economists construct abstract models about how humans behave, implicit in many of the models is the assumption that they always act rationally.

While employing such models to construct a rigorous economic theory is acceptable, it can be unproductive, and even dangerous, to utilize such models to craft monetary and fiscal policy, as well as enact rules and regulations for corporations.

Because people (acting as consumers and producers) frequently behave irrationally in the real world, many economic models are rendered useless; they fail to accurately assess and predict how decisions made by both private and public actors will affect the economy.

The most egregious omission by economists in their theories is perhaps the impact of fat-tailed events, many driven by irrational economic calculation by the so-called “rational actors” interacting with one another in the free market. Such systemic miscalculation has resulted in a multitude of financial and economic crises over the last few decades, one example being the financial crise of 2007-2008.

There is no doubt that Thaler would propound the view that the government should do it’s best to steer market actors away from performing actions that could precipitate such rare, but damaging fat-tailed events.

On the other hand, Foster does make the noteworthy case that we must be careful not to put blind faith and trust in the government to effectively monitor the markets and mitigate disaster:

But if Homer Simpson represents the average human, does not Springfield’s Mayor Quimby cast doubts on the wisdom, competence and morality of the average politician?

Indeed, if Thaler suggests that humans are irrational and must be “helped” by the government, who will “help” the government. The government, after all, is simply a group of humans as well.

If too much power held by irrational private individuals is dangerous, then if follows that the individuals in the government – an institution that has a legal monopoly on the use of force – are actually the most dangerous of all, for the irrational actions by state actors have the potential to destroy the nation.

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