The Economics Show: What economics gets wrong about human behaviour, with Richard Thaler

0:00What happens next in the story of money? Nuveen has spent over 125 years helping clients answer this question. By investing in the growth of businesses, real estate, infrastructure and natural capital, we continue to deepen our expertise across income and alternatives so investors can confidently write the next chapter of their own portfolio stories. Nuveen. Invest like the future is watching. Visit nuveen.com slash future to learn more. Investing involves risk. Principal loss is possible. Hey there, listeners. It's Michaela. Behind the money's on a break for the holidays, but I didn't want to leave you hanging, so I want to introduce you to one of our sister podcasts, The Economics Show.

0:40Every week, one of the FT's top columnists or correspondents, usually our economics columnist, Sumaya Keynes, sits down to untangle a thorny economic issue with a guest. The episode you're about to hear features Chris Giles, our economics commentator and writer of the FT's Central Bank's newsletter. He's speaking with Nobel laureate Richard Thaler to figure out why investors, politicians, and ordinary people so often act against their best interests. So here it goes. Over to Chris. There are mythical creatures that stride the land of economics. Their species name is Homo economicus. The myth says they're perfectly rational, self-interested, calculating individuals.

1:25Whole economic models have been built on this creature's ability to rationally maximise their happiness. Economists use these models to predict decisions and behaviour. Of course, everyone always knew Homo economicus was never a fully accurate description of the way people behave. It was a useful simplification. But that was easy to forget when it came to describing the results of complex economic models. If there's been a backlash against the assumption of rationality, that happened in large part because of the work of our guest on today's show. He's the winner of the 2017 Nobel Prize in Economics for showing time and again that human decisions are anything but rational.

2:09I'm Chris Giles, the FT's economics commentator. Welcome to The Economic Show from the Financial Times. You may well have guessed that in this episode I'm speaking to Richard Thaler, the economist widely seen as the founding father of modern behavioral economics, a branch of economics that integrates psychological insights into economic analysis. Famously, he co-authored the 2008 bestseller Nudge, which reshaped how policymakers think about human decision-making. And in the past month, he's released an updated version of his book, The Winner's Curse, a collection of real-world examples that challenge the traditional economic assumption of human rationality.

2:50Richard, welcome to the show. Thanks, Chris. It's nice to be here. Now, we like to do this thing on this show where we kick off with our guest rating something on a scale of one to 10. So here's one for you. When you look at the economics profession and economics in practice, how dead is Homo economicus? The scale is one, where the species is alive and kicking and very much a key player in economic models today, and 10, where it's dead as a dodo? I would say about three. Pretty healthy still. Maybe middle-aged, getting on a bit. But if we're looking for evidence in economics textbooks, then I'd say it's 1.5.

3:34Very much alive. And if we look in top journals, it's maybe around five. So this is suggesting that when people are taught economics, they get taught a model, simple, easy to calculate, easy to give results. But economists really know the world isn't quite that simple. Is that what's going on? And students, it's like it's a bit censored. And so there'll be a little box or sometimes there will be a chapter where they reveal, actually, it's not quite the way we've been saying. But we don't want to mess up your minds with this tricky stuff. Right, and the real world. Tell us a bit more about your curiosity about human quirks and how that turned into a full-blown whole academic life.

4:26It started when I was in graduate school. I sometimes say I'm the only economist who ever looked out the window or talked to people. The people I met didn't seem to be able to balance their checkbook or much less calculate the present value of their future earnings and then calculate how much they would have to save and invest and so forth and so on. And real people are also a bit nicer than economists give them credit for. They contribute to charity. They recycle their trash. They do all kinds of things that economists think they would never do. Is it easy enough to put this down to people recycle their trash or quite nice to each other?

5:14Because that makes them happy and then that resolves it as far as economics is concerned. You know, if only it were that easy. You know, this book, it started as a series of columns in a new journal in the late 1980s. And the journal had a couple features that were repeated in every issue. I wrote one on anomalies. And the point of writing those columns was to say, we can't just brush it under the table. It's not just preferences. Yeah. Once you do that, you sort of lose all discipline. So, you know, economists are fond of lecturing people. ignore sunk costs. So FD readers certainly know what sunk costs are, but just to remind you, a sunk cost is something that you've paid for and you won't get the money back.

6:14You bought tickets to a concert and you're not really feeling that great and the reviews are not so hot, but you paid a hundred pounds for each ticket and you feel like you really need to go. So people go, although if the ticket had been free, they would skip it. And you could say, well, they go because their utility is higher if they go. But the model says, no, they're as likely to go if they got it for free as if they paid for it. That model is incorrect. It is. And I've got another example of that sort of sunk cost fallacy. I was walking west of London, doing a loop around London. If you go north of a place called Uxbridge, which there's no reason why you'd know this, you see what I can only describe as the world's most beautiful modern art construction.

7:12It's part of the UK's construction of high-speed two rail. It's a bridge going over a viaduct. It's absolutely stunning. It's not going to have any trains running on it, probably until 2040, because the product is a mess. We should stop it. But is any UK government going to stop it now? It's built all these incredibly expensive pieces of infrastructure. It's going to go ahead, delayed, terribly late. People aren't going to use it. It's going to be a disaster. Anyway, it's a beautiful structure. An ancient version of the same problem was the Concorde. The Concorde was a very spiffy supersonic plane that was a joint Brit-French project.

7:54It was, in the 1960s. And the plane was beautiful and very fast, but quite small and not economic. And it was quite clear sometime into the project that this was just going to be a money sink. But they had invested too much to quit. That's exactly the same. And I think very briefly in the mid-1980s, it made an operating profit. So at that stage, once you'd sunk all the money, it was worth keeping it going. Right, once you had built the planes, it was barely... Just about an operating profit, but only barely because it was very, very expensive to run. You know, since we've talked about sunk costs, let me cut to sort of the punchline of my whole approach.

8:42When I teach, I tell my students, ignore sunk costs and assume no one else does. How about giving us another example from the latest book, Winner's Curse, which is about how people make decisions which go against their own sort of self-interest in that sort of formal sense? Sure. So there's a game we introduced called the ultimatum game. And the way it works is I give you, say, 100 pounds. And I say, you can share this with your producer. and you can offer him some amount of the 100 pounds, he gets to say yes or no. And if he accepts your offer, he gets that, you get the rest. If he says no, you both get nothing.

9:35Okay. So I know that to me as a trained economist, I know the rational outcome. You offer as little as possible. Everyone should say yes because it's better than nothing. But that's not what happens generally. Well, right. So the economic prediction is you'll offer him one pound. You won't be stingy and give him pence, but you'll offer him one pound. And, you know, he's a producer on this show. He must be enough of an economist to know one pound is better than nothing. So he takes it. And so there we have the economic theory. And what do real people do? Well, most offer half and offers of less than 20 are rejected.

10:17The profit maximizing offer is 40. So 40 is enough that it doesn't offend anyone. Right. It might offend them a little bit, but they're not enough for them to retaliate. Right. That is a lovely sort of anomaly to the standard prediction. Is it wrong for economics still to be teaching the standard model? No, it's right to teach it. So I used to teach the basic microeconomics class. And the way I would do it is say, look, here is a rational model. And going back to the sunk cost example, it's correct that you should ignore sunk costs. So that's a model of rational behavior. If we're trying to predict what other people are going to do, then we say, well, most people pay attention to sunk costs.

11:11So if I run a business and I can get people to subscribe, I'm going to have a profitable business. So it's important that they learn both parts. And, you know, the ultimatum game, the fact that people say no to stingy offers, that's a lesson that I really emphasize to business students who have had too many economics classes. Do you think they forget? Once you've been taught too much economics, you forget how the real world works. Yeah. So, you know, my mentor, Danny Kahneman, and I, the third guy, Jack Knetz, wrote a paper about fairness. Writing that paper is what caused us to create the ultimatum game.

11:59We later discovered some German guy had beat us to it. But anyway, the ultimatum game, we're in our goof. But one of the examples in that paper is a hardware store has been selling snow shovels for$25. And there's a blizzard the morning after they raised the price to$30. Is that fair? Yeah. People say no. They're outraged, except business school students. They think, of course. In fact, in their micro class, they had learned demand shifts, price goes up. So that was the correct answer in last semester's class. This semester, it's different. So there's a difference between what should happen, so how people should behave if they were all acting rationally, and then what actually happens or the way people feel about what actually happens in reality.

13:01Right. And I think it's important to teach both so people understand both. You know, there's a game I played in the FT that illustrates this point. Go on, tell me about this. Almost 30 years ago. It's called the Keynesian Beauty Contest. Okay. It has nothing to do with beauty, but here's how it works. You're told to guess a number from zero to 100 with the goal of making your guess as close as possible to two-thirds of the average guess. Okay. So if I was thinking if there was a random distribution, then you would say two-thirds of a random distribution with the median at 50 would be a third, so somewhere around 30.

13:47and then you'd think, oh, I have to go lower than that because if everyone thinks it's around 30, then they're all going to put somewhere around 30 and go lower and then maybe even lower still? What happens? Right. Well, so notice you have to think how other people think. And that's really the essence of behavioral economics. Yeah. So in the ultimatum game, if your producer were really an econ, homo economicus, he would take the pound. And that would be the rational offer. If he's a human, then 40 is the right number. So in playing this game, if you were playing with a bunch of PhDs in economics or game theorists, then the game theorists would say, well, the so-called Nash equilibrium, John Nash, that's a number that no one would change their guess.

14:41If everyone had it. If everyone had it, that's zero. Okay, because you keep saying, oh, people will be a bit lower than that, and it goes down and down and down to zero. Right, so if everyone guesses three, you want to guess two, and so forth. So if you're playing at a game theory conference, then you want to guess very close to zero. If you're playing with FT readers in 1997, the winning guess was 13. Okay. So this is a nice metaphor for how to think about the world, right? Who am I dealing with? Am I dealing with econs? Or am I dealing with humans? FT readers are somewhere in between. There were lots of FT readers, by the way, who guessed zero or one.

15:25And they had taken too many economics classes. I suppose a nagging question about behavioral economics is that it's a bit of a Debbie Downer. It's been negative. It's saying what's wrong with the profession as a whole. It hasn't put many testable propositions forward. There's been replication difficulties, which exist in lots of bits of social science. How do you respond to that? Well, funny you should ask. This book that I'm talking to you about, the first version of it was published in 1992. Why bother to reissue a book that was written 30 years ago? Well, it's to answer exactly those questions.

16:08So anomalies are things that you should be suspicious about. You know, Newton saw the apple hit him in the head. Imagine if he had seen the apple soar in the air. That would be interesting. And so I was writing about apples going up in the air. And it's reasonable to ask, do they replicate? Are they true out of sample? Are they just in low-stakes experiments, or can you see them out in the real world? So I decided, maybe foolishly, given how long it took, to collaborate with a brilliant young economist named Alex Emas to go back and look at those old columns and a bunch more I had wrote after the book came out and say, do they hold up?

16:55And the experiments, what if we run them again now? And more important, what if we look out in the real world and see whether we observe the same thing? Because there's much better data now. We, Alex and I, knew they replicated because we do them in class. And we've replicated them hundreds of times. The more important finding is all these lab experiments we now replicate in real-world findings. And in financial markets, the stakes, you know, the ultimatum game that we talked about, you can't really do it for very large amounts of money. but I've written three papers about game shows and there's a Brit game show that ends with a prisoner's dilemma and the stakes are tens of thousands of pounds and people cooperate exactly at the same stakes at the same level as they do in experiments for tens.

18:06And of course in Prisoner's Dilemma, they shouldn't do that. Let's just be clear to listeners that they should absolutely try and kill the other person as violently as possible. If they're game theorists, but, you know, thank God. Absolutely, the world is a better place if people cooperate. And I think there's a lovely bit at the end of your book. In fact, it's in a square box is the statement that anomalies help us understand the limits of theories. It doesn't say the theories are all necessarily wrong or everything's wrong, but we just need to know when they might not work in practice. before we go to the break i just wanted to ask another thing about the sort of the behavioral economics community as a whole and i suppose one of the criticisms of it has been that it hasn't it's been criticizing what's wrong with the standard model but hasn't come up with its own sort of definitive way of how the world works and how people work is that just because it's impossible In brief, yes.

19:08So, I do not think there will be a new grand theory. If you want a grand theory, stick with the one we have. Maximizing selfish agents interacting in well-functioning markets, that's a unifying theory. It's what distinguishes economics from psychology, sociology, and so forth, there won't be a grand theory. Why? Because there are too many ways that humans differ from homo economicus. We won't get a theory that will explain both why people don't give one pound in the ultimatum game, and also explains meme stocks. Quite different, aren't they? Yes. Right, it's time to take a break, but when we come back, I'll be asking whether behavioural economics has really changed economic predictions and analysis for the better.

20:26infrastructure and energy solutions that are shaping tomorrow's economy, all while aiming to deliver the resilience and returns that portfolios seek today. Nuveen. Invest like the future is watching. Visit nuveen.com slash future to learn more. Investing involves risk. Principal loss is possible. And we're back. Richard, your studies of anomalies have sparked a bit of a policymaking revolution in one particular area, which is nudge, which goes back to your publication of roughly 20 years ago. What are you most proud of in the way that actual policymaking has changed? Give us some examples of policies where people are being nudged using psychological insights to do the right thing or the thing that policymakers want, where otherwise you might have tried big incentives, lots of money, and it might not have worked so well.

21:21I think the proudest accomplishment is the reforms in pension saving. So, you know, around the time we were writing that book, we were a decade or two into a revolution in the way people save for retirement. In my father's generation, you worked for the same company all your life. You had a defined benefit pension plan, and you had no decisions to make. And we were switching over to these defined contribution plans where people have to join and figure out how much to invest. And they have to be their own portfolio manager. And they have to know how much they need, how long they're going to live.

22:05It's complicated. It's very complicated. So one thing that we suggested, sort of the most shocking anomaly, was in plans that offered employees a match, every dollar you contribute will contribute a dollar up to 6 % of your salary. Some people didn't join. That's bonkers, isn't it? Completely bonkers. So how can we fix that? Well, we could just make them join. Yeah. But something that's almost as good is just enroll them. So it used to be that you had to fill out a form to join the plan. We said, how about if you have to fill out a form to skip the plan? Well, that gets participation rates up to 90%.

22:59And people feel they've still got a choice rather than being forced to do something. Correct. Now, you might say, well, wouldn't 100 % be better? You have to get that passed. So the fact that we give people a choice makes it politically more palatable, and we're still getting 90 % of the people in. Second thing was to create easy investment strategies. So in the U.S. around that time, the only legal investment options that people could be defaulted into were money market accounts with very low rates of return. You couldn't put people into a plan where the principal could go down. Okay. And that was deemed to be safer for them.

23:47Right. Yeah. So we helped get created better default investment plans, such as target date funds or balanced funds. And in the U.S., there's$4 trillion invested in these plans. If they were all invested in money market accounts over those four years, there would be a lot less than that. This sort of gets us to the idea that humans aren't great at mental accounting, Things actually can get quite difficult. Problems that you have to solve as an individual in society are pretty hard. And we'll often use rules of thumb. Give us some other examples of how people behave plays out in a modern economy and why that's important.

24:32So, yeah, let's pick up this phrase mental accounting. Economists have many simplifying assumptions. one of which is that we can boil everything down to one number, which is wealth. And how much you consume, we can figure out just by knowing your age and your wealth. And where that wealth sits is irrelevant. How might that be wrong? Well, let me give you an example. I have a friend, we'll call her Sarah. Sarah has about£100 ,000 in her retirement account, and the stock market has gone up about 10%. So she's got about£10 ,000 more than she had a year ago. She also recently got a£1 ,000 tax refund.

25:27How much money do you think she spent because her retirement account went up versus getting this tax refund. You know, I won't make you guess, but - Well, she's going to spend more because of the tax refund because it's money in the hand. It's money in the hand. And that retirement account might be some money on a computer screen somewhere, but it doesn't feel real. And she might not even look. So, you know, there's a lot of talk right now in central banks about so-called wealth effects. Markets have gone up. We're all richer. But what behavioral economists will say is, well, who has that wealth and where is it?

26:08If it's people like Sarah who have gotten more money in their retirement account that they're not paying that much attention to and don't have access to, then they're not likely to spend any of it. And if it's people like Jeff Bezos and Warren Buffett. They've got so much money, they don't know what to do with it. I mean, the fact that they have another billion, really, you know, how many weddings does Jeff Bezos need? So to do proper macroeconomics, we need to know more about how people are thinking about their money. And, yeah. What it's in. Is it in something that they cannot touch till they're 50 or 60 or 70 or whatever?

26:51Are there limits on it? Right. I mean, housing wealth, for example, people don't spend at all. Yeah. They keep it even when people downsize or, you know, in the U.S. move to Florida or to Spain. They take the equity in the house they sell and use that to buy a house. And the heirs benefit from that. So let's be absolutely specific. We know that in the U.S. right at the moment, stock markets are at close to very high levels, all-time highs. Does this mean that people banging on about potential wealth effects, this all might be spent, it might be inflationary? Are you saying that's wrong or that's the wrong way to look at it?

27:35I'm saying to make a precise prediction about the effect, we need to know who's got that money and where it sits. And my guess is the wealth of— I'm sure the Fed knows. I don't. But for sure, the vast amount of the money sits with people who will be unaffected by it because they're so rich. And the money held by people like Sarah, they don't feel rich. And this is also related to things like when countries have a financial crisis or a recession and they have stimulus money, There are similar questions like, should it go in a lump or should they spread it out? Economics makes a precise prediction about that, which is it doesn't matter.

28:28If we give you$1 ,000 a month or$12 ,000 in a lump, it's the same. But of course, it's not the same. So we could do macroeconomics much better if we started taking off this veil of assuming that it's only wealth. Now, just to change the topic a bit, you've seen a million nudge or behavioral types of experiments. Give me an example where something didn't go as you expected. You will obviously have your own rules of thumb of how you think things are going to be. I'm just interested in where things have been weird. And you thought, oh, that surprised me. Well, I'm going to do something my students do when they don't know the answer to a question, which is to answer a slightly different question.

29:18You know, I've said that defaults are very important. And joining the plan, the default works really well. Many people think that Cass Sunstein and I advocate a similar policy in terms of organ donations. And in fact, the UK government has adopted what I think is the wrong policy. So there, the equivalent is what's called presumed consent. So in the U.S., to be an organ donor, you have to, when you get a driver's license, tick a box and say, yes, I want to be a donor. In the U.K., you're presumed to be a donor unless you tick a box. Isn't that great? Everybody's a donor. No. The reason is it's true that no one says no, but they're not the decision makers.

30:15The donors are dead. The decision makers are the family members. And you need their permission. There's no country that adopts what's called routine removal. Here's a dead body. Let's take the liver. No one does that. So they go to the family members. If the family members are told the donor signed a form saying they wanted their organs to be donated, families almost never say no. If they're merely told the donor failed to opt out, that's not very persuasive. So this is an example of taking a very powerful tool and using it in the wrong way. That's a very good answer to not quite the question I asked.

31:04So B+. I'm going to ask another question, which you might not answer. How could a nudge strategy make Donald Trump see that tariffs aren't good economic policy? Oh, my God. All right, I'm going to answer a different question, but on topic. I think on tariffs, Trump needs a course in regular economics and a course in behavioral economics. On regular economics, I'd like to introduce him to David Ricardo. David Ricardo came up with the concept of comparative advantage. We can all gain from trade, basically. Yes. Both countries gain from trade. You know, so London is good for making crumpets, not for growing coffee.

31:53You know, there's now coffee shops, three on every block of London. but it's fortunate you're able to buy the coffee beans from places that are warm and suitable for growing coffee. London's a wonderful place to do financial transactions, right? This is the way the world is supposed to work. It makes no sense for the U.S. to be making t-shirts. There's nothing about making t-shirts that we're particularly good at. And so once he's learned his classical economics. That would be step one. Step two would be to learn the ultimatum game. Offering one pound to your producer was not going to give you 99.

32:41It was going to give you zero. Trump seems to be playing a game where he doesn't think he needs the cooperation of anyone else. That's a very bad way to play the game. He likes to say America first, but none of us, you know, I'm going to sound preachy here. No one can succeed alone. No country can succeed alone. Yes, the U.S. is powerful, but we need China to build stuff, and we need places to grow coffee and do all kinds of other things. and he had made agreements, say, with Mexico and Canada that he seems to have forgotten about. And the third thing, and I don't know which category it's in, whatever you're going to do with tariffs, having them change every few weeks, that cannot possibly lead to anything good.

33:40Well, Richard, I think actually on that time, you perfectly answered the question. So thank you very much, Richard, for joining us today. Thanks, Chris. That was great. That was a really good interview. Thanks.

33:57That's all for this week. You've been listening to The Economic Show from the Financial Times. If you enjoyed the show, please do rate and review us wherever you listen. Before we go, there's an event listeners of The Economic Show might be interested in. Later this month, on November the 28th, the FT will be holding a live webinar on what the UK budget will mean for your money. Viewers will be able to put their questions to FT journalists Claire Barrett, Stuart Kirk, Tej Pyrrhic, and special guest tax expert Dan Needle. To sign up, get your free pass at ft.com forward slash budget webinar. I've left a link in the show notes.

34:37This episode was produced by Michel Frenkel-Douval with original music and sound design from Breen Turner. The executive producer is Manuela Saragossa. The broadcast engineer is Andrew Georgiades. I'm Chris Giles. Thanks for listening.

35:00The future of fixed income investing will continue to blur the lines between public and private markets. Nuveen's credit platform was built to navigate this shifting landscape, channeling capital toward the businesses, infrastructure and energy solutions that are shaping tomorrow's economy, all while aiming to deliver the resilience and returns that portfolios seek today. Nuveen. Invest like the future is watching. Visit nuveen.com slash future to learn more. Investing involves risk. Principal loss is possible.