Friday, February 16, 2007

Behavioural economics and government interventions

I tend to subscibe to a 'libertarian' outlook in life i.e. I believe that both governmental and non-govermental agencies (such as your friendly neighbourhood gangs like Bajrang Dal etc) should butt out of people's lives, socially but also economically. That is to say, I abhor the license raj system that is the norm in India. But at the same time, I am not convinced (even with long discussions with my dad) that a completely free market system is the best way either. Some things like providing a basic welfare society (making sure everyone has access to food, shelter and health care) and ensuring that education is available to everyone is, IMHO, in the sphere of the government. I just read an article in the New York Times about Behavioural Economics which seemed to make a lot of sense. The main thrust of the article was that people don't always make rational decisions (economic or otherwise) and therefore understanding the irrational behaviour is important while deciding if 'market forces' should be allowed free reign or some intervention is needed. From the article

"And yet most economic models and the public policies they inspire still assume that human beings behave like Mr. Spock of “Star Trek.” According to the models, people are guided in their decision making by a consistently rational and highly reliable sense of their own best interest."

I think this is a very interesting point. The authors goes on to discuss the new Pension Laws in the US, whereby an employer can automatically enroll all his/her employees into a 401K plan. The choice for person is not lost, he/she can choose to opt-out, but since it is human tendency to remain in status quo, once the money starts going directly into your 401K, on average people would not tend to opt-out. This law was brought in because of the absymal savings rate of Americans (it's actually negative i.e. they consume more than they earn) to encourage people to start saving for their retirement. Now if we compare the scene in India, where all salaried employees are forced to contribute to the Provident Fund, we see 2 glaring differences - (1) you cannot opt-out - I think this is important, if someone needs to use more currently due to whatever personal problems, he/she should be able to defer contributing to the PF till they are in a position to do so. (2) You have no choice of providers or of rates of return. In a typical 401K (based on the experience that I have had) you find offerings from several mutual funds. which allows you the freedom to structure your investment in the manner which you want. A caveat - some companies do have 401Ks which have only their stock for purchase, Enron was one such company and when the company collapsed, so did the savings for all the employees but this is a rare case. In fact most 401K plans suffer from the opposite problem that of too much choice i.e. too many options between mutual funds, bonds etc. The new law has tackled the 'decision paralysis' behavioural problem also by

"So the pension law instructed the Department of Labor to issue guidance to employers on how to craft a standard investment option for employees who don’t want to choose among various funds. Offering automatic investment in a balanced, diversified fund ameliorates decision paralysis and, in the bargain, advances the public policy goal of making a financially-secure retirement attainable for workers."

Food for thought, indeed.


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