The Limited Political Implications of Behavioral Economics

A recent post on Marginal Revolution contends that progressives use findings from behavioral economics to support the economic policies they favor, while ignoring the implications that support conservative policies. The short post, originally a comment by blogger and computational biologist Luis Pedro Coelho, is perhaps intentionally controversial, arguing that loss aversion is a case against redistributive policies and social mobility:

"Taking from the higher-incomes to give it to the lower incomes may be negative utility as the higher incomes are valuing their loss at an exaggerated rate (it’s a loss), while the lower income recipients under value it... 

...if your utility function is heavily rank-based (a standard left-wing view) and you accept loss-aversion from the behavioral literature, then social mobility is suspect from an utility point-of-view."

Tyler Cowen made a similar point a few years ago, arguing that "For a given level of income, if some are moving up others are moving down... More upward — and thus downward — relative mobility probably means less aggregate happiness, due to habit formation and frame of reference effects."

I don't think loss aversion, habit formation, and the like make a strong case against (or for) redistribution or social mobility, but I do think Coelho has a point that economists need to watch out for our own confirmation bias when we go pointing out other behavioral biases to support our favorite policies. Simply appealing to behavioral economics, in general, or to loss aversion or any number of documented decision-making biases, rarely makes a strong case for or against broad policy aims or strategies. The reason is best summarized by Wolfgang Pesendorfer in "Behavioral Economics Comes of Age":

Behavioral economics argues that economists ignore important variables that affect behavior. The new variables are typically shown to affect decisions in experimental settings. For economists, the difficulty is that these new variables may be unobservable or even difficult to define in economic settings with economic data. From the perspective of an economist, the unobservable variable amounts to a free parameter in the utility function. Having too many such parameters already, the economist finds it difficult to utilize the experimental finding.

All economic models require making drastic simplifications of reality. Whether they can say anything useful depends on how well they can capture those aspects of reality that are relevant to the question at hand and leave out those that aren't. Behavioral economics has done a good job of pointing out some aspects of reality that standard models leave out, but not always of telling us exactly when these are more relevant than dozens of other aspects of reality we also leave out without second thought. For example, "default bias" seems to be a hugely important factor in retirement savings, so it should definitely be a consideration in the design of very narrow policies regarding 401(K) plan participation, but that does not mean we need to also include it in every macroeconomic model.

Release of "Rewriting the Rules"

I have been working with the Roosevelt Institute and Joseph Stiglitz on report called "Rewriting the Rules of the American Economy: An Agenda for Growth and Shared Prosperity":

In this new report, the Roosevelt Institute exposes the link between the rapidly rising fortunes of America’s wealthiest citizens and increasing economic insecurity for everyone else. The conclusion is clear: piecemeal policy change will not do. To improve economic performance and create shared prosperity, we must rewrite the rules of our economy.

The report will be released tomorrow morning in DC, with remarks by Senator Elizabeth Warren and Mayor Bill de Blasio. You can watch the livestream beginning at 9 a.m. Eastern tomorrow (May 12). There will be an excellent panel of speakers including Rana Foroohar, Heather Boushey, Stan Greenberg, Simon Johnson, Bob Solow, and Lynn Stout. You can also follow along on Twitter with the hashtag #RewriteTheRules.

Firm Balance Sheets and Unemployment in the Great Recession

The balance sheets of households and financial firms have received a lot of emphasis in research on the Great Recession. The balance sheets of non-financial firms, in contrast, have received less attention. At first glance, this is perfectly reasonable; households and financial firms had high and rising leverage in the years leading up to the Great Recession, while non-financial firms' leverage remained constant (Figure 1, below).

New research by Xavier Giroud and Holger M. Mueller argues that the flat trendline for non-financial firms' leverage obscures substantial variation across firms, which proves important to understanding employment in the recession. Some firms saw large increases in leverage prior to the recession and others large declines. Using an establishment-level dataset with more than a quarter million observations, Giroud and Mueller find that "firms that tightened their debt capacity in the run-up ('high-leverage firms') exhibit a significantly larger decline in employment in response to household demand shocks than firms that freed up debt capacity ('low-leverage firms')."

Source: Giroud and Mueller (2015)

The authors emphasize that "we do not mean to argue that household balance sheets or those of financial intermediaries are unimportant. On the contrary, our results are consistent with the view that falling house prices lead to a drop in consumer demand by households (Mian, Rao, and Sufi (2013)), with important consequences for employment (Mian and Sufi (2014)). But households do not lay off workers. Firms do. Thus, the extent to which demand shocks by households translate into employment losses depends on how firms respond to these shocks."

Firms' responses to household demand shocks depend largely on their balance sheets. Low-leverage firms were able to increase their borrowing during the recession to avoid reducing employment, while high-leverage firms were financially constrained and could not raise external funds to avoid reducing employment and cutting back investment:

"In fact, all of the job losses associated with falling house prices are concentrated among establishments of high-leverage firms. By contrast, there is no significant association between changes in house prices and changes in employment during the Great Recession among establishments of low-leverage firms."