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Human Nature: The X Factor in Economic Theory


Irrationality plays a part in economic behavior. For example, people who took on too much mortgage debt helped cause the housing collapse

According to Dan Ariely, author of the recently released book Predictably Irrational and the James B. Duke Professor of Behavioral Economics at Duke University, behavioral economics is an important and useful tool for society because it takes into account the irrationality of human nature. I loved this book—and highly recommend it. I've asked Dan to give us his take from a behavioral economics perspective on the current economic situation. Edited excerpts of our conversation follow:

How is behavioral economics different from standard economics?

Standard and behavioral economics are interested in similar topics, i.e., the choices people make; the effects of incentives; the role of information; etc. However, the starting point for behavioral economists is how people behave, often in a controlled lab environment, which often leads to different conclusions about the logic and efficacy of many things, including mortgages, savings, and health care in both business and personal realms.

Won't the market fix consumer mistakes?

Why would the market fix mistakes instead of aggravating them? Behavioral economics argues that many people will make the same mistake and these will aggregate in the market. Take the subprime mortgage crisis, for example. In this case, many people made the same mistakes, and the market has worked to make the aggregation of mistakes worse.

How would behavioral economists and rational economists view the sub-prime crisis differently?

Behavioral economists view the crisis based on the assumption that human behavior is irrational: For example, when the housing market was hot, bankers assumed that their customers didn't want their house to go into foreclosure, and that they would act accordingly. The first assumption was correct—no one wanted their house to go into foreclosure. But the second assumption, that consumers knew what to do in order to make sure they didn't lose their house, was wrong.

Then, smart bankers introduced interest-only mortgages. From a standard economics perspective these mortgages allow for extra flexibility. People could pay only the interest and use the rest of the money to pay other expenses such as credit card debt, or health-related expenses. These loans would be ideal if people were purely rational. But we're not.

Borrowers were told by the banks the maximum amount they could borrow, not the optimal amount they should borrow. Given a regular mortgage borrowing maximum of $400,000 and an interest-only borrowing maximum of $650,000, would the average consumer borrow $400,000 with the interest-only mortgage and this way gain flexibility, or would they borrow to the new max? Unfortunately, people often borrow to the max, gaining no flexibility and in the process exposing themselves to a much higher risk in the real-estate market.

So, we're irrational and make risky decisions based on greed?

We are fallible, easily confused, not that smart, and often irrational, but there is a silver lining. We are innovative, creative, and adaptable. For instance, we've designed chairs, shoes, and cars to complement and enhance our physical capabilities. If we take some of the same lessons we've learned from working with our physical limitations and apply them to things that are affected by our cognitive limitations—insurance policies, retirement plans, and health care—we'll be able to design more effective policies and tools that are more useful in the world. This is the promise of behavioral economics—once we understand where we are weak or wrong we can try to fix it and build a better world.

Imagine that we took into account how difficult it is for people to calculate the correct amount of mortgage that they should take. Instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should borrow. If we had this type of calculator (and used it), I believe much of the sub-prime mortgage catastrophe could have been avoided.

Say for instance someone has a choice between leasing a Ford (F) Focus and leasing a Lexus—most people would go for the Lexus! It may not be what they should borrow, but it is the maximum and so they go for it and hope for the best.

This is one idea; there are many ways to think about how to improve our lives. And, this is why behavioral economics is so optimistic, useful, and important for our personal life and for society.

Thank you Dan! Readers if you would like to learn more about behavioral economics go to www.predictablyirrational.com. Please share your views on the irrational nature of economics.

Marshall Goldsmith is the New York Times best-selling author of What Got You Here Won't Get You There—a Wall Street Journal No. 1 business book and Harold Longman Award winner for Business Book of the Year. His newest book, Succession: Are You Ready?, will be published by Harvard Business Press in February 2009. He can be reached at Marshall@MarshallGoldsmith.com, and he provides his articles and videos online at MarshallGoldsmithLibrary.com.

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