Nearly nine million workers are now saving into a workplace pension as a result of automatic enrolment, an initiative which started five years ago. The policy was introduced because Britain’s private pension system was collapsing as employers withdrew their support for traditional schemes. But it is also a rare example of a breakthrough in economics translated into an effective policy, first in New Zealand and then in Britain.
That breakthrough came from behavioural economics and this week one of its pioneers, Richard Thaler of Chicago University, won the Nobel prize for his work in this area. So apart from the fact that behavioural economics is a strand of the discipline that actually works in practice, what exactly is it? And how does it differ from mainstream economics, whose practitioners are routinely (and often unfairly) chided for their shortcomings, including macroeconomists’ notorious failure to spot the looming financial crisis before it struck?
Conventional economics is built on a necessary fiction: that people are wholly rational in the way they behave as economic agents, seeking to optimise outcomes for themselves. The assumption is essential because irrational conduct, however common, is impossible to model. However, it does not acknowledge routine departures from rational behaviour such as harmful procrastination and biases in our thinking. This is the gap that behavioural economics fills in ways that are helpful to policymakers.
One such gap is in our approach to retirement saving. People know they should save in order to provide for themselves when they stop working. But the natural temptation is to put off any decision to save for the long-term—before it is too late and the long-term is upon us. One solution is compulsion, but that is unpopular. Behavioural economics has a more attractive answer: enrolling workers automatically into voluntary pension plans. They can still opt out but most stay in (the opt-out rate in Britain has been around 10 per cent). Simply switching the default decision from opting in to opting out makes a huge difference.
Apart from increasing access to pensions, well-designed schemes can increase the amounts that people save by putting that on automatic pilot, too. Plans can provide for a portion of future pay increases to be diverted into higher saving. By making this commitment in advance, people are more likely to save the extra amount than if they wait until they get their pay rise when a host of other uses for the extra money is likely to prove more tempting.
“David Cameron set up a behavioural-insights team after he became prime minister in 2010, which became known as the ‘nudge unit’”Another behavioural quirk that behavioural economics identifies is the extent to which we are swayed by the way choices are framed. If investors are presented with a set of funds that are mainly equities, they will tend to put most of their savings into shares, even though a higher allocation to bonds might be more advisable. Behavioural economics identifies this tendency and provides a solution by insisting on a sounder framing of the choices available. As well as supporting better investment strategies, it can promote healthier diets by changing the way that food choices are presented in canteens: salads to the front, sugary desserts to the back.
Behavioural economics is enticing to policymakers because small interventions can yield big and worthwhile outcomes. The idea is to nudge people into doing the right thing. Thaler himself has done a fair bit of nudging in getting this perspective adopted by governments, notably by writing a book entitled Nudge together with Cass Sunstein of Harvard University. Their novel approach won favour both with Barack Obama and David Cameron, who set up a behavioural-insights team after he became prime minister in 2010, which became known as the “nudge unit.”
Despite its advantages, nudging has its critics. For some, this school of “libertarian paternalism” is too clever for its own good. Policymakers may have benevolent intentions but their approach can be seen as a form of inertia selling that manipulates people’s laziness. The outcomes may be socially desirable but they undermine the principle of free choice.
Theresa May’s recent proposal in her conference speech at Manchester to meet a shortage of organs needed for transplants is a case in point. Once again this will involve a switch from opting in to opting out. Instead of requiring the explicit consent of donors before they die, this will be presumed unless they expressly request this not to happen. From a utilitarian perspective this makes eminent sense but some will regard this as violating genuine personal consent.
Yet these are disputes over the use to which behavioural economics is put. They do not call into question its main virtue, which is to enrich the menu of conventional economics. Models based on rational decision-takers will remain the mainstay of the discipline. But incorporating the insights of behavioural economics adds a welcome dose of realism.
