Behavioural economics – that branch of the subject which rejects the hyper-rational construct of Homo economicus in favour of a more realistic understanding of human behaviour – is now so firmly a part of mainstream policy design that it seems hard to believe that two decades ago almost no one outside of the profession had heard of it.
That changed in 2002, when the Israeli-American psychologist Daniel Kahneman was awarded a Nobel Prize for his pioneering work with Amos Tversky on integrating the real-world foibles of human psychology into economic analysis. Then in 2008, the Chicago professors Richard Thaler and Cass Sunstein introduced, through their best-seller Nudge, the wonderful possibility that clever policy might actually subvert the innate biases identified by Kahneman and Tversky. This, they claimed, could be used to achieve the Holy Grail of liberal government: getting people to make better choices of their own accord.
By 2015, behavioural economics had even hit Hollywood, with Thaler becoming surely the only economist ever to have appeared in an Oscar-winning film (a cameo in The Big Short). The subject had become, quite literally, box office. Thaler won another Nobel Prize for the field in 2017.
The policy impact of the behavioural economics revolution was no less impressive. In 2009, Sunstein was appointed President Obama’s regulatory tsar, and in 2010, the incoming UK coalition government established a “nudge unit” to put his and Thaler’s theories into practice. More than 50 other countries have since followed suit.
The success of Kahneman, Thaler and Sunstein’s ideas was due to more than just their ingenuity – they also spoke to the spirit of the age. Mainstream economics had for 30 years insisted that people act rationally and that the free market can therefore be counted on to deliver the best possible outcomes in the most efficient manner. The global financial crisis of 2008 smeared those crystalline assumptions with a gigantic custard pie.
By contrast, behavioural economics not only started from the premise that people are a tangle of emotions and mistakes, but made this the central plank of policymaking. Stack healthier food in the centre of shelves rather than off to the sides, and people’s limited attention span will mean they choose it more often. Paint the lines on the road closer together around tight corners, and people’s inability to reckon distance accurately means they will drive more slowly. Make enrolment in a pension scheme the default option, instead of requiring employees to deliberately opt in, and people’s innate inertia means that contribution rates will dramatically increase.
In the wake of the biggest proof of human folly in financial history, nudge theory offered a way to turn our flaws to our advantage.
What is not widely understood, however, is that Thaler and Sunstein’s nudge theory was only one half of the behavioural economics revolution. The other half has thus far made much more limited inroads into the public’s consciousness. With any luck, however, that is about to change; because its story is told in Under the Influence – an invaluable new book from Cornell University’s Robert Frank, another of the founding fathers of behavioural economics. If policy-makers have any sense, this book will be as important a manual in the 2020s as Nudge was in the 2010s.
Nudge theory argued that the principal problem with mainstream economics was its assumption that people act rationally, when the clear evidence of experimental psychology is that they systematically do not. As Tversky used to joke: “My colleagues, they study artificial intelligence. Me, I study natural stupidity.”
From the outset, Robert Frank saw the fundamental problem with the canonical model of human behaviour differently. Its Achilles’ heel was not an unrealistic standard of rationality, but the insistence that an individual’s behaviour can be usefully understood in isolation from the behaviour of their peers. Mankind is the quintessentially social animal – so every human decision is in reality made under the influence of others.
Stripping economics of its commitment to individualism turns out to have momentous consequences. One rich seam that it opens up, which Frank explores at length, is peer pressure – or, to give it its technical name, the phenomenon of behavioural contagion. Our new familiarity with the Covid-19 pandemic makes this a particularly compelling concept.
Study after study of everything from smoking and healthy eating to tax compliance and knife crime has shown that we are all heavily influenced by the behaviour of our friends, relatives and immediate neighbours. We are much more likely to be swayed by this than by any more deliberate attempts to direct us, from commercial advertising to government regulation. If you doubt these findings, just reflect for a moment on the entire business model of Facebook or Instagram.
The policy implications of this crucial fact are simple to state but easy to miss: the social costs or benefits of certain behaviours are much larger than the immediate personal consequences. Anti-smoking policy should be motivated not by the damage to an individual’s own health, nor by the potential burden on the NHS, nor even by the impact of passive smoking on others. What is most significant is that an individual’s choice to smoke makes it far more likely that their friends will also do so. The same logic applies for much less obvious cases such as the so-called public health approach to violent crime pursued successfully in Glasgow some years ago, and so sorely needed in London today.
The assertion that peer pressure matters may sound like a statement of the bleeding obvious. But a second core concept that emerges from Under the Influence’s insistence on taking society seriously is much less intuitive – and even more important. This is the notion of the “positional arms race”, and its role as the engine behind many of today’s most socially, environmentally and politically damaging dynamics.
This simple but powerful concept is one of the few fundamental insights that economics has to offer: that what is rational on an individual level is often not rational on the level of the group as a whole.
The locus classicus is the crowd at a football match. Each individual spectator thinks – quite rationally – that they could get a better view by standing up. If everyone follows this logic, however, they will all end up with just as poor a view as they started the match with. What makes sense for the individual cannot be generalised – to do so is to commit a “fallacy of composition”.
Once one gets the hang of this idea, one begins to see it everywhere. Here, too, the Covid-19 pandemic happens to provide a highly relevant current example, in the shape of the kind of public health ordinances being put in place across the world.
Many fit and healthy young people argue that the escalating injunctions against travel and socialising are over the top. From an individual perspective, their logic is sound: there does indeed seem to be a very low risk to their own health from such behaviour.
At the level of society as a whole, however, their logic is faulty: the activities in question will almost certainly increase illness and death among the elderly and infirm. When it comes to epidemiology, reasoning from one’s own individual perspective involves a fallacy of composition. Likewise, the stockpiling of medicines, sanitisers, food and toilet paper: these are privately rational but socially detrimental actions.
The genius of Frank’s behavioural economics is to show what happens when such conflicts between individual and social rationality apply in the most basic economic context of all: how much money people spend, and on what. The disastrous result, he argues, is the emergence of what he calls positional arms races.
The idea originates with a distinction that the late British economist Fred Hirsch drew between so-called positional and non-positional goods. Non-positional goods are those whose value to you is unaffected by how much of them other people have. Your annual holiday allowance, for example, is a non-positional good. If your boss gives your colleague an extra week off, it doesn’t make yours worth any less. Holidays aren’t a zero-sum game.
Positional goods, by contrast, are ones whose value depends intrinsically on how much of them you have relative to everyone else. Housing, for example, is a classic positional good. If someone else buys a flat in the catchment area of a school that Ofsted rates as outstanding, there is one fewer flat in the area available to you. With positional goods, it is not enough for you to succeed: everyone else must fail.
The existence of positional goods creates a profound economic paradox. The rational response is to try to outbid your competitors in order to get what is best for you and your family. But if everyone follows that logic, all will end up back where they started – only with a lot less money to spare.
Left unchecked, the result is a vicious circle of ever more excessive spending which is individually rational, but collectively self-defeating. Real resources, which could be usefully deployed elsewhere, are wasted in a futile jostling for position.
This is the economic version of an arms race. Frank argues that over the past half century this phenomenon has led to uncontrolled spirals of expenditure, on everything from housing and education to weddings and cars, which has left everyone far more stressed, but nobody noticeably better off.
Look no further for the reason an average family could comfortably get by on one professional salary in the 1960s, but even a two-salary family is today only just about managing. The second salary is the ammo now needed to keep up in the positional arms race for the accoutrements of a normal, middle-class life.
The good news is that because the positional arms race is an ancient economic phenomenon (apparently there was a constant need to control competitive overspending on funerals in 5th century BC Athens), there is also a time-honoured solution. It is to tax spending on positional goods – thereby imposing the fiscal equivalent of an arms control treaty.
The really remarkable fact, which is difficult for people to accept, is that nobody would lose. The rich would still live in larger houses and drive fancier cars than the rest of us. But overall, houses would be smaller and cars less fancy. Fewer resources would be wasted on gilding the lily to no ultimate effect and hundreds of billions of pounds would be freed up to spend on intrinsically worthwhile, non-positional goods – or indeed, for those who prefer longer holidays, on doing nothing at all.
The behavioural economics set out in Under the Influence represents a fundamental challenge to traditional economic theory. Frank not only furnishes a fresh and compelling diagnosis of many of the social and economic anxieties felt most keenly in the West today, but offers a simple and time-tested recipe for what to do about them. Yet what really makes this book urgent reading is that it has the unmistakable ring of a theory whose time has come.
In 2014, the political commentator Ian Dunt warned in the Guardian that beneath the UK’s apparently unflappable exterior, its democratic culture was under mortal threat from “a private entity dedicated to changing our behaviour without our consent and totally exempt from scrutiny”. He was not referring to the surveillance capitalism of Facebook or Cambridge Analytica. He was talking about the surveillance liberalism of the (then recently part-privatised) nudge unit of the British government.
Perhaps Dunt’s warning sounds a little histrionic now: there is much to like in what nudge theory has achieved. Yet his criticism conveyed an important truth – and proved unhappily prescient. Nudge theory homes in on the irrational mistakes to which we are prone and seeks to correct them through surreptitiously. Whatever the substantive merits, the unavoidable impression is of clever wonks tricking stupid subjects into doing what’s best for them. In an era allergic to elites and experts, that no longer sounds like an innovative solution: it sounds like part of the problem.
The behavioural economics of Under the Influence could hardly be more different. It focuses on the enormous economic wastage all around us – which results from decisions that are individually rational, but collectively self-defeating – and it shows how to defeat this problem using the traditional tool of taxation. As such, its message chimes perfectly with the basic instinct of today’s European and American electorates: that they are not the problem – the system is.
Dunt’s scepticism of nudge theory has therefore turned out to be merited: voters have turned against its mandarin style. Fortunately, the best that behavioural economics has to offer is yet to come. What’s more, for those voters, it is right up their street: Under the Influence explains how they really can take back control.
Felix Martin is the author of “Money: the Unauthorised Biography” (Vintage)
Under the Influence: Putting PeerPressure to Work
Princeton University Press, 296pp, £22
This article appears in the 18 Mar 2020 issue of the New Statesman, The final reckoning