Wafiq Islam
Can Behavioural Economics solve particular social and economic problems?
“In theory, theory and practice are the same. In practice, they are not.”1 This quote by Albert Einstein
encapsulates the problem of Behavioural Economics; although this discipline provides logically coherent
economic analysis, through psychological insights into human behaviour, which can theoretically
address current social and economic problems, there is plenty of scepticism amongst economists and
policymakers on whether these solutions are practically applicable. This essay argues there are usable
ideas from Behavioural Economics to deal with the following particular social and economic problems;
1) Global Economic Slowdown, 2) Environmental Degradation and 3) Poverty.
Global Economic Slowdown
Problem
In September 2008, when America’s sub-prime mortgaging market collapsed, the global recession had
begun. Many economies, especially in the West, are now burdened with substantial debt and tight
austerity measures, leading to negative economic growth and high unemployment. How can
Behavioural Economics boost the global economic recovery?
Solution
The origin of this recession is down to our inability to control and use ‘Animal spirits’. ‘Animal spirits’
refers to the inconsistent and restless nature in the economy and the relationship of economic agents
with uncertainty. Sometimes these ‘Animal spirits’ freeze our logic, other times it inspires our decision
making. These spirits can force us to go against standard economic thinking. There are five aspects of
‘Animal spirits’ that affect our economic decision making, which can be summarised by this Animal Spirit
Equation2:
+/- ANIMSP = (CON + FAIR + PSTORY – NSTORY – MI – CORRUPT)
Animal Spirit (ANIMSP); It can be either positive or negative
Confidence (CON)
Money Illusion (MI)
Stories; Positive Stories (PSTORY) and Negative Stories (NSTORY)
Fairness (FAIR)
Corruption (CORRUPT)
This equation represents an aggregate sum of all economic agents’ ‘Animal Spirits’. In order for the
global economy to recover, aggregate ANIMSP must be positive, with CON, FAIR and PSTORY
outweighing NSTORY, MI and CORRUPT. However, ANIMSP must be close to zero as possible to ensure
consistent, non-risk behaviour. Higher positive ANIMSP will lead to over-exuberance in the markets,
causing asset bubbles and ignorant regulation of finances- all of which were the causes of 2008 crisis. A
more negative ANIMSP will suppress confidence and thus, contract economic growth.
Increase Confidence
Strong confidence is essential in a recovery. Governments must impose a positive ‘Confidence
multiplier’2; that is, a multiplier which represents the change in income that results from one unit
change on confidence. Confidence is based on certainty and information. Firms and consumers assess
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the given information to formulate a rational prediction of their future profit or income and then, make
a rational decision that will actualise their goals. When firms or consumers have information that was
available to them, they do not necessarily act on it rationally because they are uncertain on whether the
information itself is trustworthy. Therefore, governments must assert confidence into the economy by
issuing trustworthy facts, not empty promises, to increase certainty and thus, stimulate economic
growth. For instance, George Osbourne announced, during his UK Budget in March 2012, there will be a
reduction in co-operation tax to 24%- a fact that appease investors and firms. Certainty encourages
producers and consumers to invest and consume because they can trust the information and thus, act
on it with rationale.
The prevalent danger governments face is ‘overconfidence’3. Overconfidence occurs when economic
agents act on their own unjustified opinions to maximise their objectives because they assume their
reasoning for conducting certain actions is correct. Moreover, they illogically believe future patterns will
resemble past ones without sufficient calculation- known as ‘representativeness heuristic’3- and thus,
assume conducting same actions will produce the same result. Yet controlling overconfidence is very
difficult because it arises from our natural inclinations to ‘want more’.
Remove Money Illusion
There is an extreme macroeconomic assumption that everyone sees beyond the veil of inflation2. Yet
this veil, for instance, can easily be covered through nominal price indexation. This is an example of
‘Money illusion’ - a psychological effect in which people have an “illusionary picture of their wealth and
income is based on nominal dollar terms, rather than real terms” 4. This is a detrimental effect because it
provides a false sense of security of economic agents’ finances which may lead them to decisions with
undesirable consequences. To remove money illusion, governments must remove nominal values from
all financial transactions and attach real values to them with purchasing power parity. This will ensure
that firms and consumers are aware of price inflation and as a result, they will make real expectations of
the economy and adjust their expenditure or investment accordingly so that their debts are sustainable.
Regardless of how many times one attempt to remove money illusion, there will always be some
economic agents prone to the effect and will lose out because of their inability to take in actual figures.
Furthermore, in times of recession, real values give a depressing view of one’s finances which
psychologically decreases one’s confidence and expectation of the economy.
Eliminate ‘negative’ stories and rumours
‘Negative’ stories or rumours can easily disrupt the market. For example, in August 2011 French Banks,
such as Société Générale, almost went bankrupt because the ‘Mail on Sunday’5 claimed French Banks
would go into insolvency, causing ‘havoc’ in the Cac 40. Inversely, governments should insert positive
stories or rumours (PSTORY) to insert confidence into investors to invest, igniting a positive multiplier
effect. These stories do not necessarily have to be entirely true but exaggerated enough to increase
investment (I) or consumption (C), without creating unsustainable monetary bubbles, increasing
aggregate demand and thus, real GDP. Reducing the impact of negative stories depends on whether
investors will ignore outside information to gain an ‘edge’ in the stockmarket but rely only on
information that is available.
The biggest problem, however, is the transmission of rumours and stories are so rapid within markets
that it is extremely difficult for all agents to perceive a common meaning of the same positive rumour or
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story because interpretation is subjective- not all agents possess equal evaluative faculties to correctly
dissect information.
Increase Fairness
Fairness is an important issue yet it has been pushed into a ‘back channel’2 in economic thinking
because the world economy, by its capitalistic nature, promotes a ‘zero-sum’ get-rich scheme. Economic
agents want to be fair but are insulted, if accused to be unfair, or are upset, if others are not fair. Take
income inequality as an example. It seems fair to lower income families for governments to tax highly
high income earners whom have surplus disposable income. In contrast, high income earners would
disagree because they argue they have worked hard in their high pressured jobs and thus, should be
rewarded. We can only increase fairness by minimising unfairness sectors which are socially and
economically important. For example, we must be fair to pensioners who are economically inactive and
need help paying for their cost of living.
Yet, how does one define fairness? Some argue fairness needs to be sacrificed in order for economic
growth to occur such as reducing unemployment benefits. In short, the global economy faces a problem
of quantifying and qualifying fairness of economic agents from independent perspective.
Reduce Corruption and Bad Faith
One must decrease ‘Corruption’ and ‘Bad Faith’ which originates from three areas; 1) Greed or ‘selfserving’ bias: we all have the natural tendency to act selfishly, 2) Lack of punishment: over the last
decade, many people conduct corrupt activity because everyone else is doing so without being punished
and 3) Deregulation: society has allowed financial activity to loosely develop leading to several scandals
such as UBS ‘rogue trader’6. Humans cannot control what they desire, but they can self-train their minds
to live without its desire. Governments must impose tougher regulations and penalties on financial
misdealing and corrupt activity.
It is difficult to quantify any external factors, which affect corruption, and deicide the appropriate fine.
In fact, it is costly and impractical to constantly monitor all economic agents’ activity.
Conclusion
Employing Behavioural Economics to assist the global recovery could have successful impact if all
solutions are universally conducted. ‘Animal Spirit’ Equation, at face value, provides clear choices of
factors we must manipulate but is ultimately flawed on the grounds it cannot quantify and qualify these
factors objectively.
Environmental Degradation
Problem
A pressing issue is the deterioration of the environment through “the depletion of resources, the
destruction of ecosystems and the extinction of plant and animal species” 7. As the world population
increases, economies are consuming more natural resources to produce more output, resulting in
excess negative externalities. How can Behavioural Economics address this situation?
Solution
The solution proposes three necessary actions which stress clarity, unity and co-operation:
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1. Engagingly present and convey independent facts on the environment to the public.
2. Socially influence citizens to become ‘environmentally friendly’.
3. Greater international and collaborative effort between governments since environmental
degradation transcends national borders.
Governments must reduce a “pool of conflicting ideas3” about environment degradation coexisting
within society. These conflicting ideas often lead to confusion as to which fact is correct. If governments,
supported by independent environmental organisations, such as Friends of the Earth, can draw public
attentions to the fact the environment is increasingly unfit for future generations, this will force people
look after the environment. This should be conducted via ‘Face-to-Face3’ communication- direct
interpersonal communication between the firms and households and the government- because the
government can assert greater psychological influence and society‘s members feel more involved with
the cause.
The lack of collaborative political will to deal with environmental challenges must be addressed because
there is little public support for dealing with environmental problems. Governments must impose a
‘Social Attention Mechanism3’ which generates a sudden focus of the public on the environment by
explaining these issues because positive changes for the environment will only come if policymakers
illustrate environmental stewardship is a benefit of society as a whole.
By earning the domestic public support for environment preservation, only then can governments
internationally work with each other to effectively set up realistic ‘environmental’ targets which must be
universally agreed. Environmental degradation can cross between borders. Therefore, all countries
should contribute funding a ‘satellite environment monitor’ which observes the movement of
environmental degradation. This will increase knowledge of accountability for these effects.
Is the solution too naive?
This solution is based on the unrealistic assumption that politicians and policymakers are perfectly
rational and will make decisions to maximise environmental preservation. The solution also discounts
financial and time lag costs of ‘satellite environment monitor’ which many governments will not be
willing to accept. In short, the solution is naive.
Conclusion
The behavioural economics solution makes a valiant attempt to solve the problem through its simple,
logical theoretical policies but ultimately is hindered by its impracticalities and naivety.
Poverty
Problem
The United Nations define poverty as “a denial of choices and opportunities, a violation of human
dignity means a lack of basic capacity to participate effectively in society8”. The inaccessibility of
education, healthcare and social security has deprived millions of people of a basic standard of living.
Can poverty be minimised in the long run with Behavioural Economics?
Solution
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The solution uses a Behavioural Economic Framework9, formulated by Canadian economist, Hersh
Shefrin, known for his pioneering work in behavioural finance, focusing on three major themes in human
choice:
1. Cognitive biases in decision-making including emotional and rational basis that can only be
examined through heuristic analyses.
2. Perception biases in decision-making that are a function of how problems and solutions are
framed.
3. Cost-benefit and risk analysis of the human aspect of decisions that highlight extra-rational
choices.
Often poverty is misunderstood through cognitive biases; that is distorted judgment which occurs in
particular situations leading to irrationality. Poverty is an issue everyone emotionally dreads to
experience. However, the government can capitalise on this fear. The government must draw out and
utilise the public’s emotional pains of poverty to turn their sympathy into empathy through ‘Face-toFace’ communication. Governments should randomly select people, rich or poor, in society to live in the
worst poverty associated countries for 5-6 weeks and experience the hardships of life (people will be
financially compensated). After their experience, these people would go back to their country, publish
their experience as a journal and give talks about it to their friends, family and in public assemblies who
then tell their friends and so, a ‘story-telling’ chain starts. The outcome is that these told experiences
will inspire people to help eliminate poverty.
Perception biases occur when people's beliefs are distorted by faulty perceptions. Developed countries
often perceived the poor with the inability or unwillingness to prosper. As Amartya Sen10 said, “poverty
in and of itself is a result of capability deprivation that further degrades the ability of the poor in helping
themselves”. Governments within poverty-hit countries should provide a clear understanding of the
poor’s choices and incentives to massively help them with their decision-making. Developed
governments could help poorer governments by ‘framing’ solutions and choices which optimally
promote “right” behaviour through appropriate incentives. By implementing mental filters through
cultural influences, people in poverty will understand the goals of their governments more easily; which
is to create a better standard of living.
Although many governments are intrinsically motivated to ‘do the right thing’, governments must assess
whether their own finances are strong enough to sustain their own economy and help undeveloped
economies. In other words, they must conduct a cost-benefit and risk analysis to understand whether
any human decision will make a difference in the elimination of poverty. One proposal for governments
is to create a ‘Helping’ tax where taxpayers accept some their taxes to be redistributed to poorer
countries. The tax contribution would mainly lie on firms and high income earners. However, this would
appeal to them, consequentially speaking, as it would improve their philanthropic image.
Solution creates more problems than it solves?
Public cynicism may consider the ‘story-telling’ policy, in the long run, is implausible because people,
who were sent on these trips, could have been paid huge sums of money to appear ‘apathetic’ on
poverty. Secondly, one’s perception biases make one overestimate the constraints of one’s policies and
overlook its potential costs. Finally, practically abiding and implementing these policies, in a time of
uncertain and fearful economic conditions, is extremely difficult.
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Conclusion
Poverty is very hard to eliminate with any solution. Behavioural Economics can be used to increase
awareness of poverty and thus, make people act on the issue. However, this depends on the state of
public; does the public want to help the poor in these difficult economic times?
Final Analysis
In the final analysis, Behavioural Economics provides arguments for flexibility in our economic and social
decisions and adds a qualitative, human element, complimentary to the mathematical economics
approach. Although it suffers from impracticalities, Behavioural Economics is constantly evolving and
sooner, with the enhanced research apparatus, solutions from this discipline can be practised to address
more social and economic problems.
Bibliography
1. Albert Einstein > Quotes > Quotable Quote. Available:
http://www.goodreads.com/quotes/show/66864. Last accessed 4th April 2012.
2. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters ... By George A.
Akerlof, Robert J. Shiller. 9th edition. Princeton University Press.
3. Robert J Shiller. (2005). Robert J Shiller Irrational Exuberance. 2nd edition. Random House:
Currency Books.
4. Money Illusion. Available: www.investopedia.com/terms/m/money_illusion.asp.
5. Fears over French banks. Available: http://www.economist.com/node/21526382.
6. UBS 'rogue trader': Loss estimate rose to $2.3bn. Available:
http://www.bbc.co.uk/news/business-14965438.
7. Definition of environmental degradation. Available:
http://www.fwrgroup.com.au/environmental-degradation.html.
8. Defining Poverty. Available: http://www.polity.co.uk/keyconcepts/samples/lister-chapter.pdf.
9. Shefrin, Hersh. Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of
Investing. 2002.
10. Sen, Amartya. Development as Freedom. 1999.
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