Those who studied advanced economics between 1960 and 2000 were bullied into believing that people were rational and that therefore economics was the study of rational behaviour. Deep down everyone had our doubts, some more than others.

In the 1980s Amos Tversky and Daniel Kahnemann stood economics on its head: far from being rational optimisers seeking equilibrium, they said, people were irrational and didn’t really know what was the best choice. After 2000 this has become the received wisdom of economics.

One day I found a book with an intriguing name: ‘Misbehaving’. It was by Richard Thaler, the economist who wrote ‘Nudge’. The paperback only costs about ₹500. That was 10 years ago. For some reason, I never got around to reading it.

Limits of ‘irrationality’

Last month there was a heated discussion on the limits of treating irrational behaviour as the bedrock of economics. So I finally read Thaler’s book. He defines misbehaviour as when people don’t behave as economics expects them to: rationally.

The book describes a large number of fascinating experiments and situations where people don’t seem to know what they are doing but are happy. Thaler’s overall message is clear: the economics of 1960-2000 was a big con in that it was all make-believe.

In one place he says how John Maynard Keynes, the Bible writer of macroeconomics, thought people were actually quite irrational.

He referred to this as animal spirits. His great insight was that widespread ownership of shares makes markets less efficient because in a closely held company the owners have a better sense of the company’s intrinsic value.

Psychology play

Given below are some examples from the book.

Psychology plays a huge part in them. In his very experiment, Thaler found that his students were happier getting 95/137 than 72/100 because they felt better. That’s all. They felt better.

Then there’s the Groucho Marx theorem’s version in economics. Groucho had said he would never want to belong in a club that would admit him. Likewise in economics a rational person would never buy a stock that another rational person was willing to sell.

This drove a stake through the heart of the efficient market’s hypothesis that in such a market the price is always right. But if the price is right, why trade at all? There’s nothing to be gained.

Another crucial finding was that loser stocks yield better returns than winner stocks. I don’t have the space here to fully explain what they did. Suffice it to say that they showed this to be true. So much for the efficient market hypothesis, then, of beating the market.

Policy Factor

Another finding of huge relevance to India which used tax subsidies to increase savings. Apparently, this is simply not the case. It’s far better, instead, to have new but automatic savings plans offered to employees by their employers.

Once again, you need to read the book.

Thaler has another insight that’s of direct relevance to India: when there are so many choices to be made, an individual needs to be guided. He calls it “libertarian paternalism”. Basically, you don’t reduce choice by making things compulsory. You leave the right to choose intact and instead make things easier for people to choose.

The book is a virtual treasure trove of highly valuable policy insights that the Finance Ministry would do well to force its officers to read.

It’s called “dimag ki batti kholna”.

Find the book here.

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