How Does a Nudge Win You a Nobel? / by Adam Howard

A few weeks ago it was announced that Richard Thaler had won the 2017 Nobel Prize for economics for his work in behavioural economics.

This came as music to my ears because, as you might have read here, I am huge fan of another Nobel laureate, Danny Kahnemann, who won the same prize in 2002 for his work as an experimental psychologist in showing that over years and years humans build up banks of “heuristics” or rules of thumb that they use for decision making, rather than employing our much-vaunted logic and rationality.

Thaler has taken Kahnemann’s work and built on it, making a strong case that the famous “rational economic agent” doesn’t really exist and that in many cases people, and by extension markets, don’t act rationally.

Here is a link that provides a brief overview of some of Thaler’s theories:

Why Richard Thaler Won the Nobel Prize

Behavioural economics is a growing body of work and is now rivalling rationality for the position atop the pile of economic theory.

It throws some shade at rationality by showing how psychological, social, educational and emotional factors influence individual’s financial decisions.

Here is a link that explains behavioural economics:

Behavioural Economics in a Nutshell

The three main pillars, though, are that:

-          95% of decisions humans make are based on “heuristics” or rules of thumb (more on these below);

-          Humans use “framing” for almost all their decisions.  Framing is the way we use stories and stereotypes to understand events and then make decisions on what to do; and finally

-          Market inefficiencies:  the mispricing and irrational decisions that result from the above use of heuristics and framing.

Here is an old school, real world example of heuristics at work.

Thousands of years ago, our old mate is going into battle against the neighbouring tribe and before the battle he killed a rabbit to eat after the battle.

He and his mates won the battle and he thought to himself afterwards “Must have been killing that rabbit that swung the odds in our favour.  I’ll have to do that every time before we have a battle.”

Seems simple, but that’s it in a nutshell.  And each of these heuristics or biases have a name. 

Here is an awesome link I found that includes ALL the heuristics, referring to them as cognitive biases:

Cognitive Biases Defined

The above rule of thumb could be the availability bias, where we overestimate the likelihood of unlikely events just because one of those unlikely events JUST happened, like killing a rabbit and then winning a battle.

But then, if you read through the list, it could be a few of them….

Now, before I go on, I should say that these biases are actually really useful, and are born from the constant and relentless work of our animal brain that is endlessly monitoring our environment, searching for threats, identifying patterns, providing feedback that everything appears to be OK.

They save time, and are right a lot, until they’re not….and are super useful “when timeliness is more valuable than accuracy…”

See if you can add up every decision you make during a day (it’s a lot) and then imagine how little you would get done if you had to slow down and think about every decision deeply before taking action.

Jesus…..

The other interesting thing about these biases, and the part of the brain that employs them, is that they don’t eat up a lot of energy.  How could they?  You are using them thousands of times a day, so they need to be light weight and efficient.

So, is it surprising that we use these little rules to help us make light of this seemingly insurmountable pile of work?

But what about when we have a BIG decision to make?  Something that requires rational decision making.

Surely then, being the intelligent beings we are, we can then switch on our human brains to help us make a good decision?

Well, we can, but our heuristics are so powerful that they tend to override a lot of the good work our human brain can do.

I’ll give you an example.

Buying a house.  Regarded as the biggest single purchase most people will ever make.  Should be the ONE time when we decide “Right, shut up fast brain.  Slow brain!! Turn on, man.  Need you now!”

Here are how 2 biases work during the purchasing process that result in inefficient results.

First, the purchase price.  It is listed on Domain, or Realestate, or REIWA.  It’s a number…and that number sticks in our heads, and we obsess about that number. 

How far below, or above that number should be offer?

What if someone else offers more and we miss out?

This is called “anchoring”, where we pay too much attention to one single piece of information when making a decision.

Maybe the property you are looking at is a little too expensive?  Maybe it will stretch you? 

Or, maybe there is some doubt in your mind that the house is worth what’s being asked.

But you just HAVE to have this house, so you go looking for reasons to support your need to buy it.

It’s got exactly what you are looking for.  Great location.  Nice style.  Will take ages to find another one that will tick all the boxes.

And on the basis of those thoughts, you make the offer that’s a little too high.  And BANG!!  You buy the house.

This one is called the “confirmation bias” where you either only pay attention to, or specifically go looking for evidence that supports rather than challenges the decision you WANT to make.

Why, though?  Why do we continually allow ourselves to be this lazy and make poor decisions?

Simple.  Because using our prefrontal cortex is hard.  It’s tiring.  It eats up huge amounts of energy

Here’s an example.

Complex communication is one of the primary tasks taken care of by our human brain, our slow brain, the home of rational thought known as the prefrontal cortex (PFC), or the cerebral cortex.

Experiments have indicated that one of the most tiring and energy sapping mental activities is making small talk (without the aid and assistance of massive amounts of booze or drugs…).

Using the PFC to listen, interpret, frame and respond appropriately again and again.

So tiring that afterwards people are more likely to ditch a diet and eat badly, or miss the gym and go home to watch TV.

And it’s the same with the other “executive functions” the PFC takes care of:  differentiating between good and bad, choosing between different future outcomes, determining future consequences of current actions and determining what is and is not socially appropriate behaviour.

Tiring….

So what do we do?  We abdicate responsibility for a lot of important decisions to our fast brain.  It’s easier. 

Result?  A lot of the time, it doesn’t matter.  But some of the time it’s bad, man; real bad.

What do I mean “bad”?   I dunno, maybe Global Financial Crisis, World War II, US invasion of Iraq, mass shootings…. 

That type of bad.

Anyway, back to our Nobel Laureate.

Thaler saw this and started researching these instances of irrationality decades ago, during the golden years of Neo-Classical Economics and the age of Homo Economicus (the rational economic agent).

Between 1987 and 1990 Thaler wrote a regular column called “Anomalies” published in a mag I’m sure everyone reads, “The Journal of Economic Perspectives.”

I know, I know.  Maybe you DON’T read it, so here’s an example of his work.  One column, that ended up being published as a book, was titled “The Winners Curse”.

In short, the winners curse says that in most cases the successful bidder at auction will pay more than the true market value of an asset.

If everyone acted rationally, they wouldn’t, but everyone doesn’t act rationally, so they do.

Acting rationally in a competitive market means no emotion, access to and consumption of all the available and relevant information and then processing that rapidly, and walking away from the opportunity or project if it doesn’t tick the boxes.

From there Thaler moved onto work on how governments and corporations could help people make better choices, and he called this help a “nudge”, which lead to the development of nudge theory.

Example? 

It’s not really economics, but you know when you have been using your laptop on battery for ages and you get the warning box pop up and tell you you better plug it in soon?  Nudge.

Or when you drive off down the road without your seat belt on and the warning chime starts, and then accelerates and gets louder the further you go before putting it on?  Nudge.

A couple of financial nudges we are probably familiar with include:

-          Increasing taxes on cigarettes to discourage smoking;

-          Double demerit and double dollar value fines on long weekends; and

-          Discounts offered for early payment of bills.

So, a nudge can be used to either encourage or discourage behaviour.  And generally the nudge has been given because the cost of either behaving that way, or failing to behave that way has been deemed too high.

Example.

-          The public health costs of smoking exceed the cost of enforcing that new tax and the encroachment on individual liberty;

-          The public health and insurance costs of car accidents exceed the extra policing costs; and

-          The cost of chasing delinquent debtors and of potential business failure exceed the cost of the discounts offered.

There are a couple of nudges in place in Australia in the property game you might all be familiar with too:  the first home owners grant, and the ability to claim interest on debt used for investment purposes, and other expenses related to that investment as a tax deduction (otherwise known as negative gearing).

Now, you can tell what the government wants the population to do by not only what nudges are in place, but the current conversation about those nudges.

So, at present you get NO grant if you buy an established house, but you DO get a reduced rate of stamp duty if you buy something for less than $530,000.  In fact, if you buy for less than $430,000 you pay no stamp duty at all.

So, there is a nudge encouraging young people to buy a house.  Why?

Well, it’s the easiest way to create new money in an economy.  First home buyers have NO home loan debt, and when they buy their first home it is likely they will go from $0 in debt to about $350k straight away, and that money goes to another member of the economy and is then spent.

This act of spending is then subject to a multiplier effect:  depending on how that seller spends the buyer’s funds they will flow into the economy and have a positive impact.

But why provide a grant for those who build?  Why encourage that type of behaviour?

Well, the funds for a new house and land package deal will probably go about 50/50 to the seller of the land and the builder contracted to build the house.

If we say the average cost of this new house and land package is $450k, then about $225k will be paid to the builder, who will then use those funds to pay for the raw materials and pay his contractors, amongst other things.

And those suppliers and contractors then take that money and spend it on…well, living and stuff.  Food at Coles, swimming lessons for the kids, dinner with the family, and on the money flows.

So, economists have advised the government that money spent on building a house has a greater impact than money spent just buying one, so the nudge is greater for first timers to build.

Now, there was a time when the powers that be were keen to nudge us all towards investing, once again because the money we spent was often borrowed, and borrowed money is often newly created money and an increased volume of money feeds economic growth and on and on and on and on….

So, tax incentives were provided to investors.  A nice nudge meaning you could own investment properties and run them at either an actual loss or a paper loss and end up with a nice tax refund at the end of the financial year.

Has anyone noticed what’s happening lately, though?

The powers that be don’t like property investing anymore.  It forms “bubbles” that can result in large losses for borrowers and banks and potentially more widespread damage.

But the nudge to foster investment is now too sacrosanct; its assumed to be part of the statutory landscape and is a part of millions of Australians financial plan.  Can’t get rid of it.  It’d be un-Australian.

So, what to do?

How about get the banking regulator (APRA) and the corporate regulator (ASIC) to put pressure on the banks to apply their own nudges to discourage people from taking out more investment debt?

Maybe that’d work?

Higher interest rates for investment debt, refusal to allow interest only terms and Loan to Value Ratio caps are all nudges meant to say to the customer “look, we will lend you money for this, but we’re not crazy about doing it….”

And maybe this WOULD work, if the nudge was big enough, like it is with cigarettes.

A packet of darts will now cost you about $25, which means only the most ardent smokers are left in the market.

I am not suggesting this should or will be the case, but rates for investment debt need to be a lot higher than what they currently are if the nudge is to work.

But then, with mortgage stress already hitting lots of households, a large and sudden lift in rates for investment debt could cause more trouble than it solves.

So, we are left with a confusing landscape. 

An enormous market in which almost everyone plays; one where there are nudges for us to get involved.

But where more nudges have only recently been introduced to stop certain types of behaviour, but where the players aren’t aware the stuff they want to do isn’t what the banks want to do.

Maybe we should ask our Nobel Laureate to have a look and see if he can do a better job, because things look a bit messy to me….