Is behavioural economics wrong?

Could it be that a cornerstone of behavioural economics is just plain wrong? A new paper by Fed economist Laurie Pounder poses this question.
She compared the actual spending of 2000 Americans aged between 53 and 73 to the spending that‘s predicted by a standard model of optimizing consumer behaviour. And she found something remarkable - that, in one important respect, the optimizing model predicts spending well:

The average propensity to spend out of current income is similar to predictions of optimal consumption under uncertainty in a dynamic stochastic model.

But of course, it’s not just current income that should determine spending. So too should net wealth and expected income.
And here, Ms Pounder did find that consumers didn’t behave as the rational optimizing model predicts. However, the deviation was in exactly the opposite direction from what behavioural economists claim. The propensity to consume out of expected future income and net wealth was lower than the optimizing model predicts.
Far from being irrationally spendthrift, therefore, people are irrationally prudent.
Now, you might object that this is because they were too optimistic about their income expectations. Not so. Ms Pounder obtained these not from asking them directly, but by estimating future years of work, social security incomes and likely pensions based on past contributions.
This finding flatly contradicts a key presumption of behavioural economics, which is that people save too little. For example, in Nudge, Thaler and Sunstein claim (ch 6) - whilst acknowledging that it’s a controversial point - that Americans are saving too little. Similarly, in Animal Spirits (ch 10), Akerlof and Shiller say conventional theories of saving are “wrong” and that “most people undersave.“
Ms Pounder’s, though, is not the only research which questions this. This paper (pdf) by John Karl Scholz has estimated that most Americans are saving optimally. And this famous paper (pdf) by Martin Lettau and Sydney Ludvigson also found evidence that consumers are rational and forward-looking.
The issue here is a deep political one, not just an academic matter. Behavioural economics implies that a task for politicians is to protect people from themselves. However, if people behave rationally and prudently, this might not be necessary. Instead, the task of politics is to protect people not from their own stupidity, but from other people, bad luck and from their rulers, whether these are in government or boardrooms.

Comments

[Kit]

The obvious flaw in behavioural economics is if people are irrational and imprudent then surely it applies to politicians too.

To paraphrase you:

"Behavioural economics implies that a task for people is to protect themselves from politicians."

[Nicholas Davis]

Really interesting paper, thanks for highlighting it. Without farming it out to people far smarter than me for investigation, I can't fault the methodology or data set, and yet extending the conclusions to say that the average US consumer is irrationally prudent to me doesn't seem to fit well with aggregate data of US savings rates, at least intuitively (but I'm often wrong).

Some possible explanations and ideas that might reconcile irrationally low savings rates in aggregate with the findings of the paper (flying in the face of Ockham's razor, I know):

1) Older cohorts exhibit significantly different consumption behaviour from younger cohorts, either due to generational issues or lifecycle shifts (they are in a better position to be able to judge future income, better at budgeting, and become as a whole far more risk averse).

2) All cohorts behave as described by Pounder, but this is only rational based on the experience of growth and income *so far*. Therefore, while consumption is irrationally prudent based on historical evidence, looking at future liabilities that have yet to directly affect the average person, such consumption is irrationally exuberant in the long-term.

Personally I'm biased towards behavioural economics, so take these points with a pinch of salt, but I wonder if either of them have any explanatory power.

Nick

[Luis Enrique]

presumably it's something to do with aggregation, but how is the very low / negative aggregated household savings rate over recent years (well, pre-2008) reconciled with 'saving too much'?

Talking of behavioural economics, I recently came across a book you might enjoy Chris:

http://press.princeton.edu/titles/7610.html

[Nick]

I suppose one key question is, do government's behave more rationally than consumers when dealing with public finances. If they don't, that would be a fairly good prime facie reason to avoid regulating consumer behaviour.

[Leigh Caldwell]

A corrected link for the third paper (Lettau and Ludvigson) is at http://faculty.haas.berkeley.edu/lettau/papers/LettauLudvigsonJF2001.pdf

This is a very interesting and important area and I'll be responding in more detail shortly.

[odograph]

I think my question is the same as Nicholas' ... if this is true, where are the savings?

(Did over-buying in homes count as savings in this model? Interest payments?)

[Tom]

If Ms Pounder didn't ask the subjects for their future expectations, but calculated them separately, is it not possible that they were *pessimistic* about their futures (which would not be a surprise in the current climate) and therefore spent (rationally or not) according to those pessimistic predictions, rather than to more realistic predictions?

[Roger]

I think the key is obviously the weighting given to life event risk.

While it may seem pointless saving at all in an economy where interest rates are low and property and equity values are soaring, most Americans now have to factor in the strong possibility of falling ill and having to suddenly pay outs very large cash sums for medical expenses deductibles and co-pays (assuming they have any health insurance at all).

Similarly without a real welfare safety net and with the threat of losing health insurance being fired is a vastly more frightening prospect for an American worker than it is for most Europeans.

I suspect that as a presumably tenured academic with both a job and fully comprehensive health insurance for life actually has a rather different definition of what constitutes 'irrational prudence' than teh very large majority of Americans who are not so blessed.

However I also suspect that in answering surveys these same Americans might well over-optimistically under-rate these risks themselves - but still save
at rate commensurate with the real level of risk.

I also wonder if Americans savings are for these reasons more subject to churn?

As it is not all atypical for a normal working family to pay $10,000 p.a. in out-of-pocket medical expenses even without a catastrophic accident or illness, I suspect that although Americans may be stashing the money away at a considerable rate it often doesn't stay in their bank accounts long enough to register strongly in the savings rate statistics.

How you might prove this is another question.

[ad]

"She compared the actual spending of 2000 Americans aged between 53 and 73 to the spending that‘s predicted by a standard model of optimizing consumer behaviour."

Presumably many of these people would like to leave an inheritance to their children and grandchildren. Does the model allow for that?

[Roger]

Spot on on the age factor.

Given that IIRC Medicare doesn't apply to 53-64 year olds but that this age bands still has quite high incidence of various expensive diseases (CHD, diabetes, cancer etc) you'd expect this pop to save more just to cover the high risk costs of being ill in America.

Plus they are also more likely to have paid off any mortgage and will also if they are still employed be earning top salaries for whatever their job is.

So they (or at least the younger majority of the study pop) will simply have more spare cash anyway - and being 53+ years old what are they going to spend it all on?

While I am also sceptical about behavioural economics I'd want to see a follow-up study with a younger and more representative age group before drawing any conclusions from this one.

[MPO]

"assuming they have any health insurance at all"

Don't the large majority of Americans have health care?

[Steve]

Good post on behavioral economics! Thanks for the article!!

[Samantha Peppercorn]

Interesting read. I thought all Americans had private health care.

[Payday Loans]

Uk has a very good private health care, luck to be here.

[Payday Loans Uk]

Presumably these people would like to leave an inheritance to their children and grandchildren but i dont think this model will allow that.

[Paul]

I can only hope the US never ends up with a health care system such as the UK and Canada have. People are impulse buyers, instead of taking care of themselves for a minor health issue, it's off to the Doctor, money be darned.

[cartier watches]

This is just one idea, and perhaps displays no more than my limited imagination. If there are better ideas out there, that amount to more than "implement something called "market socialism" and then - alacazam! - full employment!" then I'd love to hear them. http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html

[Cash Loans]

I think the UK can be proud of what it has although people do take advantage of it.

[Ryan]

The health care system here in the UK is great! As the commenter above said though, people do seem to take advantage of it which is a great shame.

[freetv]

great info