Human nature vs free markets

Arguably some of the best critiques of the loonier end of free market thought these days come from a psychological perspective. Behaviourial economics undermines some of the assumptions that lie at the heart of the many free market arguments, most notably the idea of rational economic decision-making.

This may sound like an obscure little branch of academia but such a view is wrong for two reasons. First, it is genuinely surprising the extent to which some people in the City take behaviourial economics seriously. In fact there is a kind of sub-genre here known as behaviourial finance which looks at behaviour in the capital markets. Even mainstream proponents of shareholder value have recently begun to draw attention to irrational and inefficient decision-making within the capital markets (supposedly where all the best brains hang out). Worth a read here is Robert Shiller's excellent Irrational Exuberance.

Secondly, behavioural insights have been a major influence in recent pension reform proposals in the UK. The Pensions Commission's full report includes a section on behavourial economics in its analysis (see chapter 6), and the recent White Paper on Personal Accounts includes a fairly comprehensive trashing of the idea that there is a well-functioning market for certain financial products. One could argue that it is the 'inertia' insight from behavioural economics that swung the pension reform debate behind the quasi-compulsory Personal Accounts model.

These arguments continue to rage back and forth. I was just sent an interesting paper about the failure of US workers to join 401-k schemes (I can't link directly to it but you can download it here). It's fascinating to see how hard it is to interpret people's decisions about saving. This paper seems to come down more on the side of rational decision-making (people who say they can't save becaue they don't have enough money tend to be on lower incomes). But they also question how accurate that can be when the same types of people do not opt out of schemes when auto-enrolled.

I'll bung up a list of books/papers in this area shortly.