It has often been observed that, although the decisions of economists could promote economic growth, such decisions may not be really rational ones. Economic models evolve predictions that are consistent with the micro-level data on decisions including experimental evidence. In this context, the primary work of behavioral economists centered around an experimental base before they could divert their attention to real markets and field data. Later developments in the field of behavioral economics gave it a status to involve behavioral economists in the policy decision-making processes of governments. The ideas of behavioral economists have contributed to several fiscal policy changes and tax reforms of the government. However, the behavioral approach to policy decisions does not imply that the policymakers should behave purely as paternalists (a style of government in which the desire to help, advise, and protect may neglect individual choice and personal responsibility) or interventionists (a style of government which interferes in the economic matters) in their approach. This section discusses the behavioral consequences for policy evaluation signifying the impact of behavioral economics on policy decisions of governments.
Form of Government
Behavioral economists in general are in favor of a government that is involved in actively stimulating individuals to overcome their cognitive limitations. Through this the behavioral economists enable the individuals to follow their own preferences and ensure their own well-being. Though behavioral economics does not insist on an interventionist or paternalist role of the policymakers, it is inclined more towards an interventionist government. The behavioral economists prefer an interventionist government capable of reducing the economic inequality which is a consequence of the existing economic or institutional structure (Benjamin and Laibson, 2003). Behavioral economics therefore appears to be averse to the position that the people are put to a disadvantageous position because of economic inequalities. For instance, it may be the case that the behavioral economists would feel morally obligated to help individual citizens indebted to the credit card companies charging exorbitant rates of interest or it would like to help people who do not possess considerable wealth to save for their retirement by investing in various retirement or pension plans that are really beneficial to them. Perhaps it is this philosophy of the behavioral economists that establishes the connection between 401 (k) pension plans and behavioral economics which is the central focus of this paper. Thus behavioral economics is capable of influencing the way the economic principles are applied to resolve political issues. It also deals with ideological situations where the government would be able to repair the bias and fallacies in the policies in a paternalistic way.
Behavioral Economics and Paternalism
The relationship between behavioral economics and political ideologies can be established by a study of the impact of behavioral economics on policy decisions taken by the governments following such political ideologies. This is evident from the fact that the policymakers have to take into account the motives of all the actors in the economy before they arrive at any policy decision. Behavioral economics provides a strong base to forecast the likely actions of these players in a given economic environment. The policies in order to be successfully implemented should consider the moves of private actors represented by consumers and firms and the actions of the public or government which is responsible for formulating and enforcing the policies (regulators, bureaucrats and politicians represent the ‘public’ actors). The institutional environment prevailing in the economy which provides the base for the interaction of the private and public actors is another factor that depends on the consideration of the economic policies. Of all these participants of the policy-making process, behavioral economics deals mostly with behaviors of the private actors.
Behavioral economics research and literature focused on the private actors have identified that elements like bounded rationality, slow learning, framing and lack of self-control as the basic mistakes leading to ‘bad’ decisions by the consumers and firms. These mistakes in the decisions play a vital role in the success of the implementation of the policies. Simon (1957) in his work has extensively discussed bounded rationality where the actors fail to consider all the available options and information in decision-making. Novick (1990) is of the opinion that the actors do not garner the required insight from a variety of applications which drastically limits their power to learn. The issue of ‘framing’ has been researched by Ariely, Loewenstein and Prelec (2003); Johnson, Hershey and Meszaros (1993) and Tversky and Kahneman (1971). Lack of self-control leading to internal conflicts within the actors to choose between long-term objectives and short-run goals resulting in instant benefits is another mistake identified as self-destructive by scholars (Laibson, 2003; Choi, Laibson and Madrian, 2002; Gruber and Koszegi, 2002). The various aspects of human behavior identified by behavioral economics add invaluable strength to the policy-making process from the policy analysis perspective. It is to be noted that behavioral economics has dealt with these aspects of human behavior, in contradiction to rational or classical economic models. With regard to the ‘public’ or government actors two prominent issues have been identified over time. First, since the government actors mostly pursue their own interests, it is not possible to expect any benevolence from them (Frye and Shleifer, 1997; (Shleifer and Vishny, 1998). Secondly the government actors are not exceptions to the identical biases as suffered by the private actors.
Adoption of the policies of possessing irrational warfare during WW I, 1919 Prohibition Amendment and the policy of providing large public housing adopted during 1960’s are some of the examples of irrational decisions of government actors which failed miserably in the various periods of time.
Another consequence of the behavioral aspects of private actors doing a mistake in their decision can lead to a repercussion of electing unscrupulous leaders to form the government. Unfortunately there is no mechanism to limit the powers and controls of a government that has come to the power under democratic means but subsequently turns out to be bad in respect of a majority of countries. Such a situation might lead to issues like biased journalism, political advertising, misuse of political authority, favoritism and many other forms of adverse propaganda which eventually will determine the fate of the people as well as the continuance of the government itself.
Institutions are the other set of actors which will have their influence on framing the policies of the government. Apart from the governments as the electoral institutions where the effect of making a wrong decision by the people would lead to bad consequences, ‘markets’ represent another key institutional setup that leads to ambiguous implications for the principles of paternalism. Markets as institutions can create special vulnerabilities for market participants and can also exploit the participants. Thus free markets can protect the participants from some mistakes while they cannot safeguard the interests of the actors from some other mistakes. This phenomenon analyzed in conjunction with the findings of behavioral economics would lead to successful policy-making decisions on the part of the policymakers.
Policy Proposals under Behavioral Economics
This section presents a discussion on some of the policy proposals from a behavioral economics perspective.
a. Stimulating Saving Potential
Research established the connection between psychological variables such as defaults, deadlines and automatic accelerators and the saving pattern of people and they have identified a tremendous impact of such variables on the saving behavior (Madrian and Shea, 2001; (Choi, Laibson and Madrian, 2003; Benartzi and Thaler, 2003). The impact of traditional economic variables like interest rates has been found to be negligible on savings decisions of people. The role of 401 (k) subscription has been one of the subjects of study by Madrian and Shea (2001) and Choi, Laibson and Madrian, (2002). The interventions in the form of changes in the options for the 401 (k) plans (either optional or automatic) or on the basis of advice of a financial consultant (Benartzi and Thaler, 2004) meet the requirements of benign paternalism since such interventions do not anticipate any positive outcome on the intended beneficiaries. It may be noted that benign paternalism (Choi, Laibson and Madrian, 2003) has the potential of encouraging a desirable behavior and at the same time providing the consumers the chances of choosing ultimately for their own benefits. This particular quality of benign paternalism therefore makes it is possible to structure most successful behavioral intentions.
This relationship between the choice of the employees and the decisions on the intervention by the companies gives rise to two consequences in the policy issues. First there has been no place for the involvement of the government since the interventions have been decided by the firms. Second such a situation implies that the private actors can encourage the employees to save more and therefore it can be said that the private actors have a strong influence on the saving potential of the employees. Behavioral economics thus identifies the critical role of the private actors on the national policies.
b. Asset Allocation
One of the principles of behavioral economics that the private actors tend to make errors in decisions and would thus affect the formulation of policies is evidenced by the fact that there are blatant errors committed in asset allocation decisions. First the employees may decide to hold a significant proportion of their retirement wealth in the stocks of their own companies. Continuing the example of 401(k) plans, Choi, Laibson and Madrian, (2003) observe varying proportions of considerable holdings of the 401(k) assets being invested in the company stock with the proportion increasing when the company makes a matching contribution in the company’s stocks. This is due to the belief of the most of the 401(k) participants that the volatility in the case of company stock would be lower than that of the stock mutual funds. However, the proportion of investment in the company stocks had risen as an after effect of the bankruptcies of companies such as Enron and Worldcom.
Second error occurs when the individual decides to keep the 401(k) assets in the form of investments in mutual funds with a high management fee. Most of the mutual funds do not earn enough extra returns to cover the high management fees thus resulting in lower average return on investments. Gabaix and Laibson, (2003) state that even in ostensibly competitive markets, investment firms charge higher markups because of the actions of the consumers who are poorly informed in this respect. Alexander, Jones and Nigro (1998) observe that many of the investors do not have the knowledge of the exact amount of charges they are made to pay to the firms managing their investments. Behavioral economics can detect these kinds of errors in making investment decisions and lead to better policy decisions on the part of the private actors augmenting the economic growth of the country through enhanced savings held in better assets. Alternatively the government may prescribe the maximum management fees payable on any investment in mutual fund. In this way the government can restrict the mutual fund managements from collecting exorbitant fees from the investors. It will also help the employees and other investors to maximize the return on their investments.
c. Privatization of Social Security
The virtual insolvency of the social security system and the increase in the number of baby boomers to be taken care of by the government makes the policy with respect to privatization of social security and its behavioral perspectives more significant. This section discusses this aspect from a behavioral perspective. From purely a behavioral angle, a key aspect of social security privatization can be found in the element of ‘framing’ which forms part of the concept (Benjamin and Laibson, 2003). The budget deficits and off-budget surpluses of various social security programs raise an alarm on the need to enhance the national savings rate. This necessitates a savings boom in the county considering the large volume of aging population approaching retirement, the welfare of whom is largely the responsibility of the government. The politicians find a way to undermine the issue by adjusting the social security deficits against the budget allocation of other government accounts and thus boasting of having faced the challenge at least partially. With proper and full information and perfect rationality it will not take much time for the taxpayers to lift the veil and assess the precise position of the funding of the social security programs. It can be stated that the government uses the behavioral element of ‘framing’ as conceived by behavioral economics to adjust the budget deficits of social security.
One suggestion that can be offered in respect of this issue is that social security should be taken out of the hands of the government and the government should be refrained from dealing with the deposits on account of social security. The funds should be deployed in private accounts enabling the consumer to know the exact financial status of the funds including the current and expected deficiencies and surpluses (Benjamin and Laibson, 2003). This will put a pressure on the part of the government to reveal the true picture of the social security funds and their deployment. However it should be remembered that privatization of social security has its own shortcoming by placing the individual households who do not possess the financial wisdom to control their investments. This is evident from the behavioral perspectives of individual actions in this respect (Benjamin and Laibson, 2003). This fact is also supplemented by the lack of knowledge of the employees who invest their 401(k) funds in financial assets. Among the 401(k) participants only 25% of them understand the inverse relationship between the changes in the interest rates and their impact on bond prices (Benjamin and Laibson, 2003). In order to obviate this difficulty it is worth considering the application of regulations on the possible investment opportunities.
d. Aggregate Demand
Behavioral economists usually suggest policies, which aim to improve the wealth-creating capacity of the consumers by enabling them to enlarge their savings. However behavioral aspects of increased current consumption can also contribute to economic development. For example a stimulatory fiscal policy employing tax cuts might lead to increased liquidity in household spending. Similarly such tax cuts which have stimulating effects might infuse revived liquidity in the target households instead of aiming large account transfers (Benjamin and Laibson, 2003). Such stimulatory tax cuts may be of temporary nature and should present a extra opportunity for spending to the household. The changes in fiscal policies based on behavioral models are expected to bring positive changes in the liquidity of households. With the positive liquid position the household enjoys a higher marginal propensity to consume. Therefore it can be assumed that the behavioral models by using their inbuilt mechanisms contribute to the achievement of the anticipated positive effect in the marginal propensity to consume. Bounded rationality approach of the behavioral model predicts that the customer will not have the required knowledge or information on any possible increase in tax liability in the future. Secondly hyperbolic discounting models portray that the consumers currently would be under liquidity constraints as they would have accumulated their wealth in illiquid assets because of the fact that they hold only little liquid assets as a self-disciplining device. Alternatively the consumers have a tendency to consume the liquid wealth instantaneously for some meager gratification or other reasons. Therefore the consumers can be expected to have a larger propensity to consume out of the liquid funds available with them (Angeletos, Laibson and Repetto, 2001; Laibson, Repetto and Tobacman, 1998). The other element is the mental ‘framing’ which steers the consumer to identify the current liquid funds as available for current consumption leaving the retirement funds untouched (Shefin and Thaler, 1988). Therefore, the behavioral models envisage that the wealth transferred and available in the checking accounts of the consumers would result in the generation of a high marginal propensity to consume. These models also forecast a higher level of consumption irrespective of the fact that whether the tax cut is permanent or temporary. However, it should be remembered that in order to have a large impact, such tax cuts should focus on the households which are more likely to possess small quantities of liquid assets.
Evaluation of Policies
Apart from suggesting new ideas for introducing policy frameworks, behavioral economics has the capability of offering a thorough evaluation of policies already implemented by the governments. By applying the element of ‘slow learning’ behavioral economics enables governments to do an evaluation of the policies which are currently in practice. While traditional economic principles prescribe a spontaneous and rational response to any policy measure, behavioral economics suggests much slower response with the learning process taking years to decades.
For example we can consider the case of 401(k) plans and the evaluation process of the plan by the government from a behavioral economics perspective. Even though the 401(k) accounts were introduced for the first time in the year 1978, there was no legal status according to the plan until the year 1981. Financial history shows that until the introduction of Tax Reform Act, 1986, the 401(k) plans were unpopular among the employees with only 10 million workers taking active participation in the plan. According to traditional economic principles, as soon as the legal status of the plan is clarified there should have been a significant jump in the number of accounts. On the contrary the number of accounts and the total number of participants grew only at a slow pace with the number increasing to 23 million participants in the year 1993. This number further increased to around 45 million people by the year 2001 (Benjamin and Laibson, 2003).
Thus it may be observed that it has taken at least two decades for the 401(k) plan to acquire significance among the employers and employees and has grown without bounds after that. One of the reasons for such slow growth is the inability of the firms to allow the transition of the employees to 401(k) defined contribution plans. This may be due to the fact that the investments of the employee and employer contributions were locked up in various other defined benefit pension plans. However, after a certain period when the firms were able to shift the investments the 401(k) plan continued to grow. Another obvious reason is that it has taken quite some time before the workers and the HR executives were educated about the value and utility of the 401(k) plans and their contribution to wealth creation towards retirement.
The delay in the proliferation of 401(k) plans evidence the subtle dynamic effects of policy reforms. Changes in the assets in which investments are made have a significant role to play in the propagation of 401(k) plan. It is observed that when the 401(k) plan was introduced, relatively wealthy employees were swift enough to switch to the 401(k) plan from Defined Benefit Plans without much delay. This was possible for them because most of them were financially literate households. In addition they were not constrained for liquidity and the other most likely reason was that the firms where they were working have already adopted 401(k) plans. Because of the higher liquidity those employees were able to shift the assets swiftly and easily.
From the example of the growth of 401(k) plan discussed from a behavioral economics perspective, it can be observed that the efficacy of the plan enlarged over the period of time. However, the same effect cannot be expected in respect of every other policy reform. For instance, in the case of a major tax reform, the government cannot be expected to derive the expected benefits in the long run, though it is possible to expect a positive impact in the short run. In the long run there would be tax-shelters and tax-avoidance initiatives developed which would result in negative consequences and these initiatives would be widely understood over time taking away the positive influence of tax reforms. Therefore, from a behavioral approach, it is important to have a careful assessment of the impact of the learning effects in connection with any new policy reforms introduced or proposed to be introduced by the government.
Disunity between Experimental and Behavioral Economics
The behavioral economists consider market or economic behavior as a factor that is concerned with the individual and the testing of this behavior is to be undertaken for providing the individuals a rational and beneficial economic choice. On the other hand, the experimental economists treat the market as a mechanism that is placed over and above the individual behavior and the market mechanism is directed to assess the behavior of each economic agent in achieving increased rationality. The disunity between experimental economics and behavioral economics in the context of United States has been enlarged by the opposing political ideologies followed by the government. This has resulted in more pronounced effect of the distinction between both branches of the economics in the United States rather than in the European continent. In United States, with the emphasis only on the market as the only source of efficient source allocation of resources contributed by efficient production of goods and service, a free market spectrum is developed where the government has only a minimal role to play. The individuals in the country are provided with the right and ability to take care of their own needs and preferences on his/her own accord. The intellectual heritage as advocated by Friedrich Hayek has also distinguished the position of the experimental economists in the context of the United States where market is allowed to interact freely (Benjamin and Laibson, 2003). As against this the behavioral economists prefer to institute a government that provides more opportunities to the individuals to come out of their cognitive limitations and choose their own ways of doing business or engaging in the provision of any service. Perhaps if the choice of behavioral economists of a government that is more interventionist in nature would have prevented the country from the economic mishaps that happened recently. Thinking loudly about the political ideology of the present government in extending financial assistance to various business entities in the form of economic bailouts and Troubled Assets Relief Program (TARP) appear to be an extension of the behavioral economic principles applied to practical situations. It is advisable to conduct a small field experiment about the impact of a new policy proposal and evaluate the consequences thereof before finally proceeding with the policy reform. However, it is usual that every government takes charge with a sense of urgency and is not in a position to test the impact of new policy by waiting for a period of at least a year. Therefore the principles of behavioral economics as applied to different situations are learned in hard way by governments and after the lapse of particular time, with the only exception of 401(k) plan where time has proved the beneficial nature of the plan. The 401(k) plan has proved that it can effectively transform the attitudes of the employees towards better retirement savings plans. It has been proved that an ‘automatic enrollment has increased the proportion of employees joining the plan, although the employees who joined initially on their own opted for a conservative saving rate of 2% or 3%. However when the employees could get the advice of a financial consultant the employees raised their savings rate from 3.5% to 11.6% (Benartzi and Thaler, 2003). This has increased the net savings of the employees to a large extent and it also contributed to the economic development of the country.
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