WASHINGTON - Even before winning the Nobel Prize yesterday, Richard Thaler was a pretty successful mainstream economist. He’s the president of the American Economic Association, for one thing.
He is also, as his University of Chicago colleague, John Cochrane, once put it in a snarky blog post, “a distinguished service professor with a multiple-group low-teaching appointment”.
His ideas about public policy, as expressed in Nudge, the 2008 best-seller he co-authored with Cass Sunstein, have had great influence on both the Conservatives in the UK and the Democrats in Washington. A study he did with his former student, Shlomo Benartzi, now at the University of California at Los Angeles, has transformed the design of 401(k) retirement plans at US corporations. Oh, and he’s a principal in a $3billion (R41.13bn) asset management firm.
It wasn’t always like that, however. Thaler’s early embrace of research by psychologists Daniel Kahneman and Amos Tversky on how people actually think about probability and risk - and how that reality diverges from the models wielded by economists - was a risky, low-probability bet that economists would take such work seriously. In his 2015 book, Misbehaving: The Making of Behavioral Economics, Thaler told the story of how he came to make that bet and how it played out.
During a visit to Bloomberg headquarters in June 2015, I asked him a few questions about how economists think. What follows is a much-edited transcript.
Question: What are the most valuable things that you got out of studying economics in graduate school?
Answer: The main thing that you learn in grad school, or should learn, is how to think like an economist. The rest is just maths. You learn a bunch of models and you learn econometrics - it’s tools. Some people who are so inclined concentrate on having sharper tools than anybody else, but my tools were kind of dull. So the main thing was just, “How does an economist think about a problem?” And then in my case it was, “That’s really how they think about a problem?”
Q: One thing that’s striking - Kahneman calls it “theory-induced blindness” - is this sense that if you have a really nice theory, even when someone throws up evidence that the theory doesn’t hold, there’s this strong disposition to laugh at the evidence and not even present counter-evidence?
A: Because they know you’re wrong. This has happened to me. It still happens. Not as often, but people have what economists would call strong priors. Even our football paper, which may be my favourite of all my papers, we had a hell of a time getting that published.
Q: Over the past few years, it’s become popular to say that economists have led us astray. When you hear that, whose side do you take? It seems like you’re still a danger economist.
A: There’s nobody else ready to step into the breach. Yes, I’ve been critical of economists for having blinders on, theory-induced blinders if we want to call them that. Very early when I had decided, “Okay, this is what I’m going to do”, there was a deliberate decision made by me and my few friends and Eric Wanner at the Russell Sage Foundation, who was one of our few supporters, that this was not going to be an attempt to create a new discipline.
First of all, we still need the basic theory. You know better than anybody that we don’t want to throw away the efficient market hypothesis. We just don’t want to believe it’s true.
That’s true of all economic theories. Take (Paul) Samuelson’s groundbreaking work on the free-rider problem. Obviously, that’s a huge problem, and climate change is all about it. But if you think, “Well, that means no one will ever do anything if it’s not in their self-interest”, you’re really missing out. It’s essential that we understand things like the free-rider problem, but we also need to understand that, fortunately, humans are a little nicer than economists give them credit for. I’m actually pretty optimistic about the economics profession right now. I will say I don’t think I’ve changed a single person’s mind in 40 years.
Q: So why do you feel more optimistic about economics?
A: Because new guys come in. People like Raj Chetty. He’s the future of economics.
Q: What is it about him that you like so much?
A: Well, I mean, everything. But the reason I point to him is not just because he’s a spectacular young economist, but because he is a behavioural economist when the data tell him that he should be. At the end of my book, I talk about what we need is evidence-based economics, which I understand is kind of a cheeky term, but there are people like Raj out there gathering all kinds of evidence.
Q: You’re a fan of Milton Friedman, who wrote that it doesn’t matter how unrealistic an economist’s assumptions are. The second part of his argument, though, was that it does matter whether your model’s predictions are any good, if the data backs it up. And that second part seems to have been thrown out.
A: If you go back and read Friedman, his model of the consumption function was not that far removed from (John Maynard) Keynes. The simple version of Keynes is consumption equals 0.95 times income. Then Friedman said it should be permanent income. How did he define permanent income? The data told him that a three-year moving average worked pretty well. That model lost out immediately to (Franco) Modigliani’s life-cycle hypothesis, which used lifetime income. Lifetime is preposterous. What 20-year-old is thinking about lifetime?