APROXIMACIÓN CONCLUSIVA

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ehavioral economics got its first major public hearing shortly after I returned to Cornell from Vancouver. In October 1985, two University of Chicago Graduate School of Business professors—Robin Hogarth, a psychologist, and Mel Reder, an economist—organized a conference at the University of Chicago, home of many ardent defenders of the traditional way of doing economics. Rationalists and behavioralists were to come together and try to sort out whether there was really any reason to take psychology and behavioral economics seriously. If anyone had been laying odds on who would win this debate, the home team would have been considered the strong favorite.

The behavioral team was led by Herb Simon, Amos, and Danny, and was buttressed by Kenneth Arrow, an economic theorist who, like Paul Samuelson, deserved to win several Nobel Prizes in economics, though he had to settle for just one. The younger behavioral crowd, which included Bob Shiller, Richard Zeckhauser, and me, were given speaking roles as discussants.

The rationalists’ team was formidable, with Chicago locals serving as team captains: Robert Lucas and Merton Miller. Eugene Fama and my thesis advisor, Sherwin Rosen, were given the roles of panel moderators, but were clearly part of the Chicago-based rationalists’ side. The two- day meeting was held in a large auditorium, and every seat was taken. Thinking back on it, this conference was a highly unusual event. I don’t think I have ever been to another one quite like it.

Amos presented a new paper that he and Danny had written for the occasion. It offered some violations of economic principles that economists found especially disconcerting. One was their now famous Asian disease problem, which goes as follows:

Two groups of subjects are told that 600 people are sick from some Asian disease, and a choice has to be made between two policies. The choices offered to the first group are:

Policy A will save 200 people for sure.

Policy B offers a one-third chance to save everyone but a two-thirds chance that all 600 patients will die. When presented with this choice, most people take the safe option A.

In the alternative version, the subjects are again given two choices: If they go with option C, 400 will die for sure.

If they choose option D, there is a one-third chance of killing no one and a two-thirds chance of killing everyone.

In this case, a majority preferred the risky option D.

Offhand, there does not appear to be anything remarkable about these choices, but a little arithmetic reveals that policy A is the same as C, and policy B is the same as D, so it is not logical for respondents to prefer A over B but D over C. And yet they did, and the same results were obtained with a similar problem posed to a group of physicians. Results like this clearly made the rational camp uncomfortable. Econs would certainly not misbehave so blatantly.

Danny then presented some of our work on fairness, including our Ultimatum and Dictator Game experiments. These findings were not any more popular. The economists thought that fairness was a silly concept mostly used by children who don’t get their way, and the skeptics just brushed aside our survey data. The Ultimatum Game experiments were a bit more troubling, since actual money was at stake, but of course it wasn’t all that much money, and all the usual excuses could be raised.

The talk that gave me the most to think about, and the one I have gone back to read again most often, was by Kenneth Arrow. Arrow’s mind goes at light speed, and his talks tend to be highly layered fugues, with digressions inserted into digressions, sometimes accompanied by verbal footnotes to obscure scholars from previous centuries, followed by a sudden jump up two or three levels in the outline that he has in his head. While you work to digest a profound nugget disguised as a throwaway line, he has leapt back to the main argument and you are left scrambling to catch up. On this occasion, however, his talk can be summarized easily: rationality (meaning optimization) is neither necessary nor sufficient to do good economic theory.

Arrow began by dumping on the idea that rationality is necessary. “Let me dismiss a point of view that is perhaps not always articulated but seems implicit in many writings. It seems to be asserted that a theory of the economy must be based on rationality, as a matter of principle. Otherwise there can be no theory.” Arrow noted that there could be many rigorous, formal theories based on behavior that economists would not be willing to call rational. As an example, he noted that the standard theory of the consumer states that when prices change, the consumer will solve the new optimization problem and choose a new “best” set of goods and services that still satisfies the budget constraint. Yet, he noted, one could easily build a theory based on habits. When prices change, the consumer chooses the affordable bundle that is closest to what she was consuming before. Arrow could have gone even further. For example, we could have rigorous theories as bizarre as “choose the bundle with brand names in order to maximize the occurrences of the letter K.” In other words, formal models need not be rational; they don’t even have to be sensible. So we should not defend the rationality assumption on the basis that there are no alternatives.

As for whether rationality alone is “sufficient”—meaning that by itself, it alone can deliver important predictions—Arrow argued convincingly that rationality alone does not get you very much. To derive useful results, theorists have to add auxiliary assumptions, such as assuming that everyone has the same utility function, meaning the same tastes. This assumption is not only demonstrably false, but it immediately leads to all kinds of predictions that are inconsistent with the facts. We are not Econs and we are certainly not identical Econs.

Arrow also noted an inconsistency inherent in the behavior of an economic theorist who toils for months to derive the optimal solution to some complex economic problem, and then blithely assumes that the agents in his model behave as if they are capable of solving the same problem. “We have the curious situation that scientific analysis imputes scientific behavior to its subjects.” At the end of the talk, Arrow declared his allegiance: “Obviously I am accepting the insight of Herbert Simon on the importance of recognizing that rationality is bounded.”

But my role in this conference was not just listening to academics I admired; I was given the intimidating task of acting as the discussant for a set of three papers authored respectively by Herbert Simon, Danny Kahneman with Amos Tversky, and Hillel Einhorn with Robin Hogarth (the conference organizer). In this situation, I largely agreed with what the authors had said, so I was not sure what to do. Discussants are expected to critique and elaborate. For me to just say, “Yeah, what he said,” would not serve me well. The papers that I thought had real conceptual problems were slated for sessions yet to come. I also had to keep in mind that I was at the “kids’ table”; there were two Nobel laureates on the program (Arrow and Simon), several others in the audience, and half a dozen more that were to win prizes later. How could I make my points to such a big-

league crowd without seeming presumptuous?

I ended up deciding that my best strategy was to employ some humor. This can be risky, but I have found that if people are laughing, they tend to be more forgiving. I based my discussion on an obscure essay by George Stigler, one of the wittiest economists of his generation, and as a Chicago faculty member, he was sitting in the rationalists’ cheering section of the audience. Stigler’s essay was called the “The Conference Handbook,” and it, in turn, was based on an ancient joke:

A new prisoner arrives at a jail where everyone else has been locked up for a long time. He notices that occasionally someone shouts out a number, and everyone else laughs. He asks his cellmate what is going on and is told that they have been in jail so long together that they have all heard all the jokes that anyone knows, so to save time they have numbered the jokes. After hearing a few more numbers followed by howls of laughter, he decides to try it himself and shouts out “Thirty-nine!” No one laughs. He asks his cellmate why no one laughed and was told, “Well, some people just can’t tell a joke.”

Stigler’s essay proposed to apply the joke numbering system at conferences and departmental seminars where the same tiresome comments are repeated again and again. Stigler offered several introductory remarks, indicated by letters, followed by thirty-two specific comments that he suggested could be referenced by number. I quoted his introductory comment F, figuring we might hear a version of it soon: “It is good to have a non-specialist looking at our problem. There is always a chance of a fresh viewpoint, although usually, as in this case, the advantages of the division of labor are reaffirmed.”

In this spirit, I offered what I called the “Psychology and Economics Conference Handbook.” My idea was to list the tiresome comments I had been hearing anytime I gave a talk, those described in chapter 6 on the Gauntlet, along with suggested retorts. I figured that announcing them in advance might preempt some of the participants from hauling them out later. You can guess by now some of the comments: 1. If the stakes are high enough, people will get it right. 2. In the real world, people will learn and avoid these mistakes. 3. In aggregate, the errors will cancel . . . And so forth. For each one, I explained why the comment was not as devastating as the person delivering it might have thought.

I then concluded:

I will end my remarks with the following two false statements. 1. Rational models are useless.

2. All behavior is rational.

I have offered these false statements because both sides in the debate that will be taking place at this conference and at similar conferences in the future have a tendency to misstate the other side’s views. If everyone would agree that these statements are false, then no one would have to waste any time repudiating them.

People seemed to like the discussion. I even got a thumbs-up from Stigler as I was leaving the podium. The rest of the first day of the conference was reasonably calm.

The morning of the second day began with the announcement that Franco Modigliani had won the Nobel Prize in economics, in part for work that he had done jointly with Merton Miller, one of the primary speakers scheduled for the second day. Modigliani was then at MIT, but he had earlier been a colleague of Herb Simon’s at Carnegie Mellon, and at Simon’s urging the conference sent Modigliani a congratulatory telegram. That morning, Miller could not be blamed if he was thinking that this good news for his mentor and collaborator was bad news for him. Modigliani won the prize alone, and Miller might have felt that he had missed his chance. It turned out that he would win a Nobel Prize five years later, but he had no way of knowing that at the time. Nor did he know that morning, in this pre-Internet era, that the prize had been awarded primarily for Modigliani’s work on saving and consumption—the life-cycle hypothesis—rather than for his work with Miller on corporate finance.

In the morning festivities surrounding the news, Miller spoke briefly about Modigliani’s research. The press had asked him to summarize the work he had done with Modigliani, and, with his usual sharp wit, he said they had shown that if you take a ten-dollar bill from one pocket and put it into a different pocket, your wealth does not change. This line got a big laugh, to which Miller replied: “Don’t laugh. We proved it rigorously!”

The joke was meant to refer to their so-called “irrelevance theorem,” which proved that, under certain assumptions, it would not matter whether a firm chose to pay a dividend or instead use that money to repurchase their own shares or reduce their debts. The idea is that investors should care neither where money is stashed nor how it is paid out. But the joke actually applied equally well to the life-cycle hypothesis, since in that theory the only determinant of a household’s consumption is its wealth, not the manner in which that wealth is held, say in cash, retirement savings, or home equity. Both theories take as a working hypothesis that money is fungible. We have already seen that in the case of the life-cycle hypothesis, this assumption is wrong. It turns out, all jokes aside, the assumption was equally questionable in corporate finance, which was the topic of Miller’s talk that afternoon.

Miller’s paper had been provoked by a behavioral finance paper by Hersh Shefrin, my self-control collaborator, and Meir Statman, a colleague of Shefrin’s at Santa Clara University. In particular, they were offering a behavioral explanation for an embarrassing fact. One of the key assumptions in the Miller–Modigliani irrelevance theorem was the absence of taxes. Paying dividends would no longer be irrelevant if dividends were taxed differently than the other ways firms return money to their shareholders. And given the tax code in the United States at that time, firms should not have been paying dividends. The embarrassing fact was that most large firms did pay dividends.

The way taxes come into play is that income, including dividend income, was then taxed at rates as high as 50% or more, whereas capital gains were taxed at a rate of 25%. Furthermore, this latter tax was only paid when the capital gain was realized, that is, when the stock was sold. The effect of these tax rules was that shareholders would much rather get capital gains than dividends, at least if the shareholders were Econs. Importantly, a firm could easily transform a dividend into a capital gain by using the funds that would go to paying dividends to repurchase shares in the firm. Instead of receiving a dividend, shareholders would see the price of their shares go up, and would save money on their tax bill. So the puzzle was: why did firms punish their tax-paying shareholders by paying dividends? (Those who pay no taxes, such as endowments or those saving in a tax-free account, would be indifferent between the two policies.)

Shefrin and Statman’s answer relied on a combination of self-control and mental accounting. The notion was that some shareholders—retirees, for instance—like the idea of getting inflows that are mentally categorized as “income” so that they don’t feel bad spending that money to live on. In a rational world, this makes no sense. A retired Econ could buy shares in companies that do not pay dividends, sell off a portion of his stock holdings periodically, and live off of those proceeds while paying less in taxes. But there is a long-standing notion that it is prudent to spend the income and leave the principal alone, and this idea was particularly prevalent in the generation of retirees around in 1985, all of whom had lived through the Great Depression.*

It is fair to say that Merton Miller was not a fan of the Shefrin and Statman paper. In his talk, he did not disguise this disdain, saying that the behavioral approach might have applied to his own Aunt Minnie and a few others like her, but that that was as far as it went.

The written version of Miller’s paper was less strident than his presentation, but was nevertheless quite odd. Most of the paper was devoted to a lucid tutorial on the very puzzle that Shefrin and Statman were trying to explain, rather than a critique of their hypothesis. In fact, I know of no clearer explanation for why, in a land of Econs, firms would not pay dividends under the tax regime then in place. Miller agreed that firms should not pay dividends, but most did so. He also agreed that the model that best described how firms decided how much to pay out in dividends was the one proposed by the financial economist John Lintner, a model Miller labeled “behavioral.” In Lintner’s model, firms only increase dividends when they are confident that earnings have gone up enough such that dividends will not have to be cut in the future. (Had the model been written later, Lintner might have used loss aversion to help explain why firms are so reluctant to cut dividends.) Lintner had arrived at this model after using the unfashionable strategy of interviewing the chief financial officers of many large companies. About this model Miller said: “I assume it to be a behavioral model, not only from its form, but because no one has yet been able to derive it as the solution to a maximization problem, despite thirty years of trying!”

best describes the pattern by which they pay them. This sounds like a paper written by someone who has come to praise behavioral finance, not bury it. But Miller was neither ready to praise nor to concede. He wrote: “The purpose of this paper has been to show that the rationality-based market equilibrium models in finance in general and of dividends in particular are alive and well—or at least in no worse shape than other comparable models in economics at their level of aggregation.” So, the strongest statement Miller could muster was to say that the standard rational model of financial markets—the efficient market hypothesis, to which we will turn in the next section, on finance—was not quite dead.

Not only did Miller concede that the best model of how firms pay dividends is behavioral, but he was also happy to grant the same about how individual investors behave. He said: “Behind each holding may be a story of family business, family quarrels, legacies received, divorce settlements, and a host of other considerations almost totally irrelevant to our theories of portfolio selection. That we abstract from all these stories in building our models is not because the stories are uninteresting, but because they may be too interesting and thereby distract us from the pervasive market forces that should be our principal concern.” Take a moment to absorb that: we should ignore the reasons why people do things,

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