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December 15, 2002
David Warsh, Proprietor


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Bridging the Gaps

From the beginning, the “Anomalies” column was probably the most popular feature in the Journal of Economic Perspectives. That non-technical journal was founded in 1987 by the American Economic Association with a view to filling a gap between the enormous volume of published economic research and the writing about it that appeared in the popular press.

Cornell University professor Richard Thaler took his title from historian of science Thomas Kuhn, who had written that those troublesome facts which existing theory could not accommodate were the royal road to scientific revolution.

There followed a steady stream of articles. Thaler wrote about the Winner’s Curse (the tendency of the most optimistic to overpay in winning auctions), the Ultimatum Game (a powerful new tool in bargaining experiments), and the various mental accounts that most of us keep to defeat what otherwise would be the predicted fungibility of money — current income, retirement income, special items and so on.

He solicited distinguished co-authors to write with him on the latest research advances: Amos Tversky on preference reversals, Daniel Kahneman and Jack Knetsch on loss aversion, William Ziemba on pari-mutuel betting at racetracks and lotteries. Eventually the pieces were collected in 1992 in The Winner’s Curse. And in an article a couple of years ago, Thaler summed up his view of the prospects for economics in the 21st century.

Evolution, not revolution, would be the rule — from “Homo Economicus” to “Homo Sapiens,” as economists increasingly incorporated cognition, emotion, learning in their models.

Last week Thaler was in Stockholm, cheering as his friend Daniel Kahneman shared the Nobel Award in Economics. He didn’t win the prize, but he helped create the circumstances in which it was easy to give.

As Vernon Smith, the other winner, put it, “The focus on anomalies, beginning in the 1970s, converted the emerging discovery enterprise into a search for contradictions between [various] sorts of behavior and the results of mainstream theory.”

Today behavioral economics is a booming field. The Russell Sage Foundation sponsors a summer institute at the University of California at Berkeley. The MacArthur Foundation supports a research network on the nature and origin of preferences. Harvard’s most recent big-name appointment in economics is David Laibson, one of the leaders of the new field. Other universities are scrambling to keep up. And Thaler himself has become professor of behavioral science and economics at the University of Chicago’s Graduate School of Business

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The lectures in Stockholm did not disappoint. You can see them for yourself in webcasts on the Nobel Museum site.

Kahneman’s lecture in particular is a masterful introduction to “the ideas that were in the back of our minds when we started thirty years ago” (most of his work was jointly done with the late Amos Tversky). Indeed, by an intertwining of spartan analysis with computer-generated illustrations, accounts of pointed experiments and dabs of intellectual history, Kahneman’s talk more nearly resembles a star performance than a traditional lecture — 38 minutes that pass like 17.

The US-Israeli economist, who teaches at Princeton University, gives a lucid account of the differences between intuitive thinking and analysis. Intuitive insight is a powerful searchlight — it serves equally the chess grandmaster and those who are sure-footed in social situations. But it involves fairly basic representations, with little extra explanation or computation. There is much to be learned by going beyond.

He offers the example of a deck of cards. The size of a single card and the volume of the deck itself are apparent immediately on inspection. But the total surface area of all the cards requires a further investigation. Intuitive thinking zeroes in easily on averages, Kahneman says, but it has difficulty with sums. This leads to a general insensitivity to the size of a set — the amount of a good, the size of a sample, the rate of an outcome, the duration of an episode.

“The similarity of results obtained in very diverse studies suggests that the same mechanism is at work in all cases,” he said — a tendency to certain systematic errors in decision-making. Unlike economics, he says, psychology does not have a unified formal theory. But the few general principles of perceptual and cognitive function it has contributed so far can predict and explain a wide array of behavior, and, “to some extent, help bridge the gap between psychology and economics.”

Smith, a professor at George Mason University, tells a somewhat more complicated story in his lecture. Distinguishing between two kinds of rationality — “constructivist” and “ecological” — he makes a provocative case that economics has ignored much of what is most interesting about what it means to be human. His is an audacious program — to pose a “reciprocal” motive to the familiar self-interest of “rational” choice. It is probably better to wait to read the paper. But the quotation from Hayek with which he begins is succinct enough.

“We must constantly adjust our lives, our thoughts and our emotions, in order to live simultaneously within different kinds of orders, according to different rules. If we were to apply the unmodified, uncurbed rules of caring intervention to do visible good for the small band, or troop, or our families, to the extended order of cooperation through markets, as our instincts and sentimental yearnings often make us wish to do, we would destroy it. Yet if we were always to apply the non-cooperative rules of the extended order to our own more intimate groupings, we would crush them.”

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The Nobel Award for Economics, first presented in 1969, has been a mostly good thing. It builds consensus about what we think we know. But one bad outcome is the chasm it creates between the anointed and the 50 or so could-be economists around the world who find their relative standing diminished while they dwell in the half-lit penumbra of the shortlist, perhaps forever. One of these is Edmund Phelps, a Columbia University professor who has been at or near the center of nearly almost every interesting argument in economics since the early 1960s.

Not long after 9/11/01, “Ned” Phelps was honored in an extraordinary meeting in New York. For two days, freshwater and saltwater economists mixed and mingled as if bubbling from a single spring, to celebrate his long career. Phelps invented the so called “golden rule” of capital accumulation (put yourself in the place of later generations when discounting in the present), wrote about technical change, explored the self-perpetuating nature of business slumps, and delved deeply into the nature of work.

Most famously, writing from the left, he demolished the Phillips curve, with its supposedly reliable trade-off between unemployment and inflation. Milton Friedman made many of the same arguments separately from the right. Phelps even wrote a famously entertaining (and demanding) introductory economics text, displaying his love of old movies and opera.

Now you can see for yourself. Editors Philippe Aghion, Roman Frydman, Joseph Stigliz and Michael Woodford fought off the deadly temptation to do two volumes and instead boiled the papers from the conference down to fifteen chapters in a single book with the title “Knowledge, Information and Expectations in Modern Macroeconomics.” Paul Samuleson wrote the preface. The result is that professional economists and their students will be able to see the man clearly for years to come.

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A few last words about soon-to-be former Treasury Secretary Paul O’Neil. His friends wondered at the time of his appointment why he wasn’t named director of the Office of Management and Budget, where during the Ford Administration he had risen to deputy director. As head of OMB, O’Neill probably would have been one of the conspicuous successes of the administration.

But George Bush decided he had to find a spot for Mitchell Daniels, the former Eli Lilly senior vice president who at one point had been Ronald Reagan’s political director. When OMB turned out to be the only place Daniels would fit, that left Treasury to O’Neill. One friend says, “We probably all should have seen how this would end.”

Remember, however, the strained circumstances in which the Bush administration came to power. Reasonable persons will give nominees John Snow and Stephen Friedman the benefit of the doubt before leaping to the conclusion that the White House doesn’t give a damn about good economic policies.

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