I welcome the FCA’s occasional paper on behavioural economics. I have a shelf of books on the topic and have known for many years that the prevailing models used by regulators fail to deal adequately with the real world.
The categorisation the FCA has adopted – biases regarding preferences (regret, ‘present’ bias), beliefs (overconfidence) and decision making (faulty heuristics) each have different characters and consequences and can be addressed in different ways – is a decent tool kit.The fact that the FCA has dug quite deep into the issues and raised a lot of questions is encouraging.
The FCA rightly focuses on how firms can use biases to missell – PPI is the textbook case – and how it can stop them doing so. But the biggest losses consumers suffer are due as much to their biases as to any ‘misselling’ – all their losses on tech stocks in the dotcom boom were self-inflicted, for example. And the deep biases outlined by Daniel Kahneman in Thinking, fast and slow are not susceptible to correction through gentle nudges.
The good thing about a focus on behavioural economics is that it is as far away from box-ticking regulation as you can get.
Diagnosis of problems – usually having multiple causes – is difficult and prescription of interventions that will make things better rather than worse is even harder. So this focus on ‘qualitative’ rather than ‘quantitative’ regulation will, I hope, spill over into the rest of the FCA’s work in time.
But there is a problem with behavioural economics. The majority of academics and bureaucrats applying it still adopt the ‘bounded rationality’ model of neoclassical economics, that we have biases but are fundamentally rational, would generally like to be more so and would definitely be better off if we were.
But the evidence gathered so far by evolutionary biologists and experimental economists does not support this view.
Our long prehistory on the African savannah hard-wired us to experience loss as twice as painful as gain is pleasurable – it is not a choice we make.
The way our thinking processes derive from managing social interaction in small tribal groups means our ways of viewing the world are not based on logic. In fundamental ways, to be human is to be, in terms of the conventional model, ‘irrational’.
The flaws in the conventional view are obvious. More information – the answer of neoclassical economics to any issue where consumer choice appears to deliver poor results – can, and in finance often does, produce worse, not better results.
If you take this seriously, it’s impossible to avoid using ‘paternalism’ to make decisions on behalf of consumers (like banning certain types of small print). It is a short step from this to the notion that irrational consumers need protectors with big sticks.
An alternative view, more European than American, is that humans are and always will be non-rational in important ways.
The answer is not education, information and choice by atomised consumers but creation of socially inclusive solutions everyone can accept without thinking about them – like mandatory auto-enrolment, giant pension funds with lifestyle defaults – and a remorseless drive towards simplicity in every aspect of topics like finance which 90 per cent of the population is incapable of dealing with rationally.
And shouldn’t the FCA start by applying its behavioural insights to its own rule book?
Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning