Many believe dysfunctional behaviour in finance is due solely to distorted incentives
Out of the crooked timber of humanity, no straight thing was ever made. This famous remark of the German philosopher, Immanuel Kant, is particularly relevant to economists. “Homo economicus” is far-sighted, rational and self-interested. Real human beings are none of these things. We are bundles of emotions, not calculating machines. This matters. The World Bank’s latest World Development Report examines this territory. It notes that “behavioural economics” alters our view of human behaviour in three ways: first, most of our thinking is not deliberative, but automatic; second, it is socially conditioned; and, third, it is shaped by inaccurate mental models. The Nobel laureate, Daniel Kahneman, explored the idea that we think in two different ways in his 2011 book Thinking, Fast and Slow . The need for an automatic system is evident. Our ancestors did not have the time to work out answers to life’s challenges from first principles. They acquired automatic responses and a cultural predisposition towards rules of thumb. We inherited both these traits. Thus, we are influenced by how a problem is framed. Another characteristic is “confirmation bias” — the tendency to interpret new information as support for pre-existing beliefs. We also suffer from loss aversion, fierce resistance to losing what one already has. For our ancestors, on the margin of survival, that made sense. The fact that humans are intensely social is clear. Even the idea that we are autonomous is itself socially conditioned. We are also far from solely self-interested. A bad consequence of the power of norms is that societies may be stuck in destructive patterns of behaviour. Nepotism and corruption are examples. If they are entrenched, it may be difficult (or dangerous) for individuals not to participate. But social norms can also be valuable. Trust is a valuable norm. It rests on one of humanity’s strongest behaviours: conditional co-operation. People will punish free-riders even when it costs them to do so. This trait strengthens groups and so must raise members’ ability to survive. Mental models are essential. Some seem to be inbuilt; and some can be damaging — as well as productive. Ideas about “us” and “them”, reinforced by social norms, may well lead to results that range from the merely unfair to the catastrophic. Equally important may be mental models that create self-fulfilling expectations of who will succeed and who will fail. There is evidence, notes the WDR, that mental models rooted in history may shape people’s view of the world for centuries: caste is an example. Such mental models survive because they are reproduced socially and become part of the automatic rather than the deliberative system. They influence not just our perceptions of others, but perceptions of ourselves. To illustrate the relevance of these realities, the report analyses the policy challenges of poverty, early childhood development, household finance, productivity, health and climate change. On household finance, for example, the report notes that it makes a difference whether would-be borrowers are told explicitly how much more expensive is a payday loan than an equivalent loan on a credit card. Revealing the status of low-caste boys in a mixed-caste classroom depresses the performance of students from lower castes compared with what happens if caste is not revealed. The boys respond to how they are presented. Again, poverty is not just a lack of material resources:it undermines the ability to think deliberately. The way people think may also affect their productivity. An example is the benefits of contracts that penalise a worker for failing to meet the output targets she has chosen for herself. This is a way of closing the gap between good intentions and actual performance, such as when we agree to put money in the swearbox when we curse. We often disappoint ourselves. We may wish to bind ourselves to better behaviour, like Odysseus to his mast. Health creates vital examples. One is the importance of mental models. An obvious one is the anti-vaccination hysteria. Another, illustrated by the WDR, is the tendency of poor women to believe that the right treatment for diarrhoea is to cut fluid intake, to stop their child “leaking”. Another is the tendency of people to be put off by even a very small charge for health products. The explanation for the reluctance to pay anything may, it suggests, be because free provision underpins the norm that everybody ought to take the medicine. These then are intriguing examples of a more nuanced approach to policy. Another area where a narrow focus only on incentives is likely to be misleading is financial regulation. Many economists believe that dysfunctional behaviour in financial markets is due solely to distorted incentives: deposit insurance, the perception that institutions are “too big to fail” and a host of other explicit and implicit subsidies. Equally important, however, are behavioural norms, such as the view that the primary duty of bankers is to themselves not their customers; or inappropriate mental models, such as the widespread pre-crisis belief that house prices could not fall across the US. Regulation needs to be built on an understanding of such human frailties. It must focus on norms and groupthink, as well as on distorted incentives. How far should policy be based on these perceptions, particularly since those who make policy are, as the WDR admits, prone to all sorts of biases in their own decision-making? We are all made of Kant’s crooked timber: nobody has godlike wisdom and self-control. Yet policy must be made. It is surely better to make well-informed and realistic policy than base it on a grossly simplistic view of our true capacities. Moreover, nudging people in the direction they already want to go — by encouraging them to save, learn, behave healthily or bring up their children better — is hardly a gross violation of liberty. Yet encouragement should not slide too easily into coercion. Adults are not to be treated as children. That, too, is a social norm and quite a fundamental one.