This year’s Sveriges Riksbank Prize in Economic Sciences has been awarded to Richard H. Thaler, a professor at the University of Chicago’s Booth School of Business. The award, given in memory of Alfred Nobel, is often referred to as the Nobel Prize in Economics and brings with it an equivalent amount of international renown.
The prize was given in recognition of Professor Thaler’s work in integrating economics with psychology, noting that he “has incorporated psychologically realistic assumptions into analyses of economic decision making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes.”
This year’s prize also comes with a monetary award of $1.1 million, which Professor Thaler said he would try to spend “as irrationally as possible.” An economist with a sense of humor is a rare gift to all of us who follow the subject and possibly worthy of a prize in its own right
While the irrationality of our decisions has received most of the attention, the key word in the Nobel committee’s citation was “systematically.” It is one thing to note how consumers and investors make irrational decisions, it is quite another to discover the systematic forces that drive that decision. Understanding the system opens the door to integrating irrational decisions into economic models and forecasting.
The value of both economic models and forecasting took a wallop in the Wall Street crash of 2008 and the prolonged recession that followed — neither of which were predicted by the wonder-models we had been relying on. It was clear that we needed a better economic theory on which to build a better model. What wasn’t clear was where we were going to find such a model.
Behavioral economics promised a better understanding of human decision making and a better economic model, but remained always on the brink of the discoveries necessary to construct a new theory. Its core idea was promising enough for major universities to establish faculty positions and research groups to explore it. But it remained in the promising stage and never lifted off to deliver a system.
Professor Thaler’s work doesn’t really deliver that yet, either, but it does present a systematic approach that we needed to build a new economic theory. He began his efforts with an exploration of the anomalies in behavior that undermined the accuracy of the economic theory dependent on consistently rational economic decisions.
Thaler was not the first economist to take on the economics establishment on this subject. Over a century ago Thorstein Veblen questioned the hedonism implicit in economic theory by mocking its “economic man,” which he described as, “a lightning-fast calculator of pleasure or pain.”
In contrast to Veblen’s mockery, Professor Thaler presented a patient refutation of the rational decision-maker doctrine at the foundation of economic theory and the forecasts built on it. It took him decades, but now he has received the recognition he deserved.
Over the years, many students of economics have found themselves unhappy with the unrealistic assumptions embedded in economic theory but most economists eventually accept them as necessary to make progress in forecasting, promoting economic growth, and the other big problems of macroeconomics. Additionally, as a practical matter, getting along in the economics business requires going along with its orthodoxy.
Clearly, when it came to the orthodox economic theory’s assumption of rational decision-making, Professor Thaler was something of a renegade. But he didn’t just rail against orthodox theory. He began to formulate an alternative approach based on the psychological research findings of his friend, Daniel Kahneman. It is said that Kahneman taught Thaler psychology and Thaler taught Kahneman economics. They are both great teachers, apparently, for they each have now been honored with Nobel prizes in economics – Kahneman in 2002 and Thaler 15 years later.
The prizes have conferred legitimacy on their work in the field now known as behavioral economics, but legitimacy should not be confused with actual change in economics. While the Nobel committee praised Professor Thaler for his work in integrating psychology and economics, the two are not really integrated until the math pencils out. And that means that there is a lot of hard work yet to do
Behavioral economics is predominantly a microeconomic concept; applicable to individuals and small groups. Economic policy, though, is mostly a macroeconomic concept, applicable to large components of our economy – consumption, production, investment, savings, etc. What we have learned from Professor Thaler’s work is that it might be possible to develop the math to integrate — perhaps literally, with integral calculus — economic decisions and choices into a macroeconomic model of our economy that actually works. This is big league thinking, worthy of a Nobel prize.
James McCusker is a Bothell economist, educator and consultant.