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In my Pittsburgh Tribune-Review column of January 12th, 2007, I did my best to explain why the findings of behavioral economics do not, contrary to much belief, weaken the case for leaving markets free of government meddling [2]. You can read my column beneath the fold.
The system is the solution
There’s no disputing that each person sometimes behaves in ways that conflict with, rather than promote, his or her own well-being.
Many of us succumb to the temptation to eat that piece of cheesecake even though we know that we’ll later regret the decision. (“A moment on the lips; a lifetime on the hips.”) Many of us know that we should put that $1,500 into our retirement account rather than spend it on a flat-screen television — but we spend it on the television nevertheless.
“Behavioral economics” has uncovered plenty of evidence to confirm that people commonly act “irrationally.”
It’s tempting to conclude from the research findings of behavioral economists that laissez faire is a lousy policy. How can we trust markets regulated only by the basic laws of property, contract, and tort — that is, markets not regulated in detail by officials whose jobs are to ensure that markets function properly — to generate outcomes that serve the general interest?
Asked differently, doesn’t human weakness and irrationality make the invisible hand of Adam Smith at least a bit palsied? And, if so, doesn’t a palsied hand need some conscious guidance from caring attendants?
No.
The case for the market doesn’t require that each of us behave in textbook rational fashion. One of the great benefits of free markets is that they both reduce the frequency of irrational behavior and temper the ill consequences that would otherwise occur when people do behave irrationally.
Finding that people sometimes behave irrationally says nothing about the frequency of such behavior. By imposing costs for mistaken behavior on the individuals who behave mistakenly (and by rewarding people who behave prudently with personal benefits), markets reduce the frequency of irrational behavior.
If Joe, an adult, makes choices that harm Joe, then Joe has incentives to correct his behavior. At a minimum, no one else has stronger incentives than does Joe to ensure that Joe avoids self-destructive actions. If Joe is shielded from having to suffer the consequences of his choosing unwisely — and if he is blocked from enjoying the consequences of choosing wisely — then we can be sure that Joe would behave irrationally more frequently than he will when the consequences of his choices fall heavily upon him.
Indeed, the fact that we are not hard-wired always to act rationally and prudently strengthens the case for laissez faire capitalism. For that is the system that best motivates individuals to avoid self-destructive behavior.
Another reason why the findings of behavioral economics do not undercut the case for free markets is summarized by the slogan of the firm AMP Netconnect: “The System is the Solution.”
The case for free markets rests chiefly upon the recognition that the competition and feedback within markets tend to weed out firms and practices that do not satisfy human desires. No one acting within markets needs to aim at generating beneficial system-wide outcomes.
Such outcomes emerge “spontaneously” (as the late Nobel economist F.A. Hayek put it). They emerge through the interactions of millions of people, each with his own limited knowledge and personal weaknesses.
The market system feeds and magnifies those practices that people find useful and starves and shrinks those practices that people find to be useless or harmful.
Adam Smith understood that the system is the solution when he wrote that beneficial market outcomes are the result of an “invisible hand.”
A nice description of the importance of the market system appeared in a recent article by Washington Post columnist Sebastian Mallaby. He agrees with behavioral economists that individual investors are frequently irrational — that they “overreact to new information, extrapolate trends too far into the future and value a gain of, say, $100 less than they fear a loss of the same amount.” Surely such irrational behavior undermines the efficiency of markets.
Not so, says Mallaby: “By turning these insights into trading strategies, hedge funds sold irrationally expensive assets and bought irrationally cheap ones, moving prices closer to fundamental value.
“In their ceaseless search for profits, hedge funds have sought out inefficiencies on the financial frontier. After Hurricane Katrina, some traditional insurers recoiled from covering offshore structures, a classic example of overreaction to a bad event. Hedge funds hired academic climatologists, crunched the numbers and made a tidy profit by underwriting storm risk.”
In other words, individuals’ own irrationalities provide incentives for savvy entrepreneurs to devise ways of profiting by correcting the ill consequences of these irrationalities. The result is what my Nobel Prize-winning colleague Vernon Smith calls “ecological rationality” — rationality of the system.