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Behavioral economics: the missing link in the financial crisis?

Behavioral economics was once relegated to the fringe of academia. Now theories that pair psychology with economics have everyone from US President Barack Obama to Steve Jobs taking heed.

A crowded trading floor

Economists are increasingly interested in human behavior and irrationality

Why do we spend 100 euros on a business shirt, but drive around an extra 20 minutes looking for gasoline that's just a few cents cheaper? Why do we pay off our smallest debts first even if they have the lowest interest rates? Why is it so tough to save for retirement?

All of these questions find answers in a growing field of research called behavioral economics. If standard economics makes basic assumptions about how people should behave, behavioral economics looks at what people actually do and extrapolates meaning from there.

Dan Ariely (born 1967 in New York) is an Israeli professor of Psychology and behavioral economics. He teaches at Duke University and is the founder of The Center for Advanced Hindsight

Dan Ariely outlined many of his theories in his book "Predictably Irrational"

"Standard economics assumes that people have ordered and complete preferences. Based on those assumptions, we go ahead and make stories about how the world works," says Dan Ariely, a professor of behavioral economics at Duke University and the author of "Predictably Irrational" and "The Upside of Irrationality."

"Behavioral economics is interested in the same topics that standard economics is interested in, but we are sort of agnostic to assumptions and instead we believe in data."

Cheat? Everyone else is...

Researchers like Ariely run tests in labs and conduct field experiments to see how people react when presented with different choices and incentives. Often, subjects don't make the most efficient or rational choices.

For example, behavioral economists find that people will pay more for things when using a credit card because it delays the pain of paying. People cheat more when they think others are cheating too. And when put in different situations, people are willing to pay wildly different amounts for the same items - this goes for a cup of coffee to a new mortgage.

Irrational risk-taking

Ariely says behavioral economics might have remained in the shadow of standard economic theory if it wasn't for the financial crisis in 2008 - a massive demonstration of the irrationality of both consumers and Wall Street traders.

Specialist Joseph Morelli works on the floor of the New York Stock Exchange Wednesday, Oct. 15, 2008.

The crisis revealed that experts who were supposed to evaluate risk had failed

"If we had to choose a marketing campaign for behavioral economics, this would be it," says Ariely. "Because here is what happened: we had been doing this research for a long time. I would present it and people would say, 'this is so nice and cute. I will tell my wife about it when I go home for dinner, but clearly the argument would not apply with experts who are being paid lots of money to make really important decisions. And for sure it will never work in the competitive environment on the market.' As an empirical person, I never had anything to say."

But then Ariely and other well known behavioral economists like Cass R. Sunstein and Richard Thaler, the authors of "Nudge", got their real life example. The same risk-taking behavior they saw demonstrated in experiments among university students was mirrored in Wall Street's well trained and well paid experts.

What has the crisis taught us?

A German Mastercard

Have we learnt anything? Americans, for instance, still spend more than they save

"I think the financial (failure) in such a magnificent way got people to think. That all of those people who were supposed to evaluate risk seem to have failed demonstrated that something very basic is wrong," says Ariely. "So I think the final crisis has been very useful. Now almost three years later, the question is: will we make enough changes?"

It's a relevant question. In the United States, the Obama administration has embraced behavioral economics when designing new incentive programs for retirement saving and financial oversight, but the impact is unclear. Americans are still spending more than they are saving. Wall Street is playing the same risky game as ever. So what has changed?

A behavioral economist might say humans' desire to take risks will never change. A better question might be: what kind of mechanism can we design to save us from our own destructive impulses?

Author: Caitlan Carroll
Editor: Sam Edmonds

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