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The free market and the rise of Behavioral Economics theory

Posted by Adrian on June 6, 2007

With the sub prime and loan/mortgage market now in full meltdown in America. The issue has been raised on regulation of the uneducated, vulnerable individuals that have been, in some peoples opinion, exploited. The Subprime lending markets has been to say the least an economic disaster, that invertible will spill over to the rest of the American economy (in some cases this has already occurred). According to an recent Bloomberg article, “Subprime originations fell 10.3 percent to $722 billion in 2006 from a record $805 billion in 2005, according to JPMorgan Chase & Co. Credit Suisse predicts a 40-60 percent slide this year.”, this mixed with the huge mortgage defaults, from the same Bloomberg Article, ” mortgage defaults climb, bond investors who financed the U.S. housing boom stand to lose as much as $75 billion on securities backed by subprime mortgages, according to Newport Beach, California-based Pacific Investment Management Co.

This is a clear sign that the US housing market is in recession, and a serious one. It is time, in some economist minds, that regulation of the ‘free market’ is needed. If indeed there is a broader ‘crash’ in the markets, the argument against any kind of market regulation is that it would not stop invertible bubble bursts in the free markets. As inflated financial markets are somewhat inevitable as long as government meddles too much into finance, whether weak or over exaggerated interest rate (government banks) policy or lapse tax initiatives.

So what does the new discipline of behavioral economist offer? The free markets were always the the higher echelon of free choice. Which is why most economists would agree that humans make choices to maximize their economic wealth. According to behavioral economics people are not that rational, in fact they can and do make appallingly bad decisions regarding financial stability and wealth.

So by attaching psychology and economics together, behavior economist’s believe that they can systematically protect consumers from poor decisions, from the University of Chicago article on behavioral economics, “Traditional economics teaches that humans are rational actors who make decisions in ways that maximize their well-being. Behavioral economics, meanwhile, relies on cognitive-psychology research to relax those assumptions, teaching instead that humans have “bounded rationality”—a term coined in 1957 by economics Nobelist Herbert A. Simon, AB’36, PhD’43—and so make biased decisions that sometimes run counter to their best interests.

The “bounded rationality” theory is the curious aspect of the ‘subtle suggestion’ model, in which behavioral economics has based itself on. In other words it is a financial theory that gives people a better picture of a financial decision. How is this done? Well according to the The University of Chicago article, Richard Thaler a professor of behavioral science, economics, and finance in the Graduate School of Business suggest that we utilize the term ‘Libertarianism paternalism’. Which means that a behavioral economist would come up with a financial model, that allows a paternal suggestion to a person and hopefully guide that person in the right direction to put ones money. From the University of Chicago article, “Thaler is particularly frustrated by the argument that accepting bounded rationality implies that bureaucrats should be trusted even less and the market even more. “It’s not the point,” he says. “The point is, what can boundedly rational but well-motivated planners—a category in which I include bureaucrats, CEOs, school principals, mothers—what can they do to improve the decision making of people over whom they have influence, without restricting anyone’s freedom?”

Sound familiar? Reminds me of the furor of cognitive science and behavioral research in the 70’s. The ‘how much choice a person can make without it damaging the actual person’ theory. Can governments, CEO’s and school principles really improve decision making under a sound paternal ‘plan’ model? Can behavioral suggestion, in the most benign way really save us from ourselves, as far as financial decisions?


All ready there are calls from some economists, in light of the recent housing recession in America, to make the mortage market far more accountable which would include broader regulation of the market, as Professor Roubini of the REG monitor puts it, So do not blame excessive government regulation; it was the lack of any basic regulation that created the bubble. Do not blame Congress for being the cause of the coming credit crunch because of it totally appropriate predatory lending investigations and soon legislation. If such legislation will lead – as some recent analyses have suggested to the disappearance of one third of the subprime mortgage market, so be it as part of these subprime loans were deceptive, predatory and should have never been made in the first place. Lenders were systematically deceiving poor and uninformed borrowers, many of which minorities who had no clue of what they were getting into.”


The debate about ‘free markets’ and regulations is not a new one, the blaming game will continue as markets worldwide may face a dramatic downturn in the coming years, since the credit and housing bubbles have expanded. If we do limit a persons ability to ‘maximize utility’, how far can this regulation go? It could turn out to be an ‘out of control’ paternal exercise, where the poor are denied opportunities to expand wealth due to the fact they need to be ‘regulated’. The ideology of ‘control’ and bureaucratic complexity come to mind. Or is this following into the realms of hysteria? The point is, behavioral economics may show an interesting counter argument to the free markets, but it should be received with some caution.


People generally will want to see opportunity, no matter what the suggestion – so can the suggested ‘liberal paternalism’ be enough to ensure a right financial decision by a person? Asset bubbles will always grow and they an invertible part of cyclical economics. Could it be said that nothing can hold back the cycles of economies, much like the cycles in nature? No matter how much regulation occurs.

Links: Nouriel Roubini’s Blog

Chicago University Magazine ” Can behavioral economics save us from ourselves”

Businessweek debate on the subject of regulation in the housing market. Businessweek.


2 Responses to “The free market and the rise of Behavioral Economics theory”

  1. […] of that risk into CDO’s (as it has turned out) has been a waste of money. Can the new lore of Behavioral Economics offer some new perspective? If the world is faced with a severe economic down turn exasperated by […]

  2. Jesse said

    ups and downs will always be present in economies, but we can eliminate the bubbles as they now exist given that they are products of current monetary policy.

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