Wednesday, November 26, 2014

The Trouble with Libertarian Paternalism

CHICAGO – There are many arguments against government paternalism: apart from limiting individual choice (for example, the choice to remain uninsured in the current health-care debate in the United States) and preventing individuals from learning, history suggests time and again that the conventional wisdom prevalent in society is wrong. And, since governments typically try to enforce the conventional wisdom, the consequences could be disastrous, because they are magnified by the state’s coordinating – and coercive – power.

A clear example is financial regulation, which in many ways is a form of paternalism. In the US, the low risk assigned to senior tranches of mortgage-backed securities made them attractive instruments for banks to hold, given the relatively high return they offered. But they proved far from safe, despite the prior conventional wisdom. And, because the regulator had pronounced them safe, far too many banks overloaded on them, rendering them even more risky when the banks tried to sell them at the same time.

Other examples of the danger of the coordinating power of government paternalism abound. As I drive to downtown Chicago, I pass a series of high-rise housing projects, meant in their time to be the miracle cure for homelessness, poverty, unemployment, and crime. Today, they are seen as the best way to concentrate and perpetuate many of those ills.

Not only were the housing projects kept a safe distance from areas that had good jobs, but, with few residents experiencing stable families and livelihoods, there were not enough local examples of success to guide young people. As a result, many went astray.

The fashion today is to integrate poor households into flourishing communities. No doubt we will discover some unintended consequences in the future, and the power of government coordination will ensure that those consequences are widespread.

But some amount of paternalism is necessary in civilized societies. Social security is a paternalistic form of forced savings for old age, preventing individuals from consuming and saving as they please. It exists, in part, because individuals know that civilized societies will never stand by and watch the elderly starve. So individuals are forced to save in order to prevent them from gaming the system – not saving when young, knowing that they will be assured a minimum level of support by a humane society when old. Similarly, the mandated purchase of insurance in the Obama administration’s health-care bill is an attempt to prevent the young and the healthy from remaining uninsured and turning to the government for support only when they discover that they need it.

So, if paternalism has benefits as well as costs, how do we get the former without the latter? My colleague, Richard Thaler, along with Cass Sunstein, who currently serves in the Obama administration, wrote a best-selling book, Nudge, in which they suggest a way to reduce our uneasiness with paternalism. Essentially, by exploiting behavioral quirks, they would nudge people into making decisions that are good for them, even while individuals have complete freedom to change their mind. So libertarian paternalism, in their view, eliminates one of the main objections to paternalism – that it constrains individual choice.

For example, in deciding how their pension savings will be allocated, most people simply choose the default option in their employer-offered plan. Often, the default option is unsuitable for most individuals – for instance, it typically allocates all savings to low-return money-market funds. Sunstein and Thaler would have the employer choose a default option that works for most people, such as 60% in equities, 30% in bonds, and 10% in money-market funds.

That is the paternalistic part. The libertarian part is that the employee has the right to opt out of the default option. Because people rarely move away from the default option, the employer’s paternalistic choice prevails, and we get libertarian paternalism. What is not to like?

The problem is that the semblance of choice in libertarian paternalism is an illusion. Choice remains unexercised, because individuals do not consciously think through their decision. If their choices can be directed, is this not paternalism plain and simple, rendered more sinister because individuals are unaware that they are being nudged, and cannot raise their guard?

One response is to point out that most plans already have a default option that determines savings allocations. Sunstein and Thaler merely say that the default option should be set in a way that is good for people, and clearly they have an idea of what is good.

This, then, is the nub of the problem. In choosing the default option, the government or the employer nudges all employees into prevailing fads such as “buy equity for the long run.” This, they believe, is better than the current typical default option of putting individuals’ money into money-market funds. But it may be worse: coordinating everyone into risky asset investments may be more dangerous than coordinating them into boring investments like money-market funds.

Could there be a better alternative? What if there were no default option, and individuals were sent repeated, and increasingly urgent, reminders to choose an allocation if they did not choose one already. The conventional wisdom could be offered as a recommendation, along with explanations of why it makes sense, but it would not be the default. This would force people to exercise choice. Some people would differ from the conventional wisdom, benefiting the system by introducing some variety and resilience.

More generally, the flaw in some forms of libertarian paternalism is that the free choice that it appears to offer leaves the paternalism largely unconstrained. Would it not be far better to force conscious choice in order to limit the consequences of paternalistic mistakes?

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    1. CommentedSandeep Shetty

      Interesting article. However, I don't see how choice is an illusion in libertarian paternalism context. It will only be so if the individual is uninformed of the default decision made for him. Further, given multiple options, how likely is the individual to make a calculated decision or rely on a decision conforming to his or her surrounding so as to minimize the psychic costs involved? I think a government suggested socially beneficial choice, even on average, to begin with seems a good system. If the individual then thinks he can do better he can opt out.

    2. CommentedElizabeth Pula

      I think an interesting "counter-statement" could be an article with the title "the Trouble with predatory Corporatism". It may even start with a valid premise.

    3. CommentedPartha Sarkar

      It is true that Libertarian paternalism could be blamed for the current mess that most of the Free Market world is in. The greatest edifice of this disposition is none other than Alan Greenspan, whose easy money policies implemented by the FED distorted the risk reward system that is the cornerstone of Free market capitalism and thus forced the market participants to allocate excess injected liquidity into instruments of complete destruction. This process precipitated a downward spiral which US and Europe find themselves in where the Central Banks are forced to keep interest rates low and inject more money in the Banking system.

      However this conjecture also begs me to question the basic premise behind Libertarian Paternalism and its objectives. Are the concerned parties who hold the helm of policy setting and decision making acting as independent entities or there is a real conflict of interest? Are the Market participants trying to game the system through political lobbying and getting the law makers to dupe the whole system? The largest amount of Lobbying money in US is in fact in the Finance, Insurance and Real estate industries followed closely by Oil and Gas, energy, utilities, buildings and construction and healthcare. The number of regulations that these industries are subject to and its correlation with the amount of lobbying money is fairly significant. Now whether this correlation indicates causality is best left to experts like Professor Rajan. But personally I do see a chicken an egg situation here. The point I am trying to make is it is not clear to me whether the anomalies in the Free Market fundamentals that we see in the system are caused by Libertarian paternalism or whether the Paternalism is a result of large Market participants trying to gain competitive edge by distorting the information symmetry and level playing field for all.

    4. CommentedRobert Winter

      It strikes me that the "clear example" is largely meaningless when immediately qualified by "in many ways." Putting aside the points made by others concerning the fundamental error in asserting that it was the government -- as opposed to decisions by rating agencies, managements , Boards and the markets -- that in a meaning way assigned the level of risk to the investments, how would the author deal with the situation without government regulation? We have had more than sufficient experience in allowing financial institutions using guaranteed deposits and similar instruments to create short term profits and enormous levels of compensation, only to leave taxpayers to deal with the consequences. It was not the government that pronounced mortgage backed securities safe safe. The growth in the volume of such securities, and the willingness of many who knew better to trade in them, was based upon the enormous profits/compensation that could be generated by packaging and reselling. Regulation may not have been as effective as it should have been. But suggesting that the problem was caused by paternalistic regulation does not pass the laugh test.

    5. CommentedDiana Hinova

      In practical terms, how is the "conventional wisdom" distinguished from the default option? In my opinion, people will treat it exactly the same way, even if takes ticking a box rather than simple non-response.

      People are paradoxically disinterested in engaging critically in such exercises to a degree that's almost impossible to overcome, no matter how many and how urgent reminders you send them (these can become costly, too).

    6. CommentedProcyon Mukherjee

      Rajan’s article on Libertarian Paternalism has an element of choice theory, and the conflicts and dilemmas with a direction that does not necessarily force us to make the right choice for ourselves and our children. The root of this crisis is perhaps embedded in the virtues that Montesquieu has talked of and which are much in want in the current times. The sales pitch to which we get attracted to from potato chips, housing mortgage to riskier assets lead us to liabilities that are likely to stay attached in a manner that could bring great peril as times keep changing and new products are on the block. The risk premium that we pay and the hidden costs that only become visible as asymmetries of information are removed leaves winners and losers in a probabilistic model; the power to change the outcomes to ones favor cannot be left to the vagaries of libertarian paternalism.

      Perhaps the love for frugality would leave us more happy, notwithstanding its general impact on the larger economy, which would act at cross purpose.

      Procyon Mukherjee

    7. CommentedMichael Grisham

      There are so many false premises underlying this article that it is difficult to believe the author is approaching the topic in good faith. For example, the notion that the implosion of the mortgatge-backed securities market was due to failures inherent in any system of government regulation is tendentious at best. The regulatory regime of ratings agencies, such as it is, is non-governmental. Further, any fair-minded observer must account for the fact that the failures of the ratings agencies were created - in large part if not in whole - by the conflicts of interests stemming from the fact that they were paid by the entities they were purporting to "regulate." In short, this was a market failure, not a government/regulatory failure. Mr. Rajan's comment bears the mark of the idealogue - reasoning from conclusions, instead of from premises.

      Another faulty premise is the libertarian fantasy of "choice." Individuals are not equal actors with equal skills, equal access to information, and equal resources. The notion that an individual choosing 401k options has a real power to choose on a par with that of sophisticated market actors is flatly absurd.

      The main problem with "libertarian paternalism" is its seeming need to pay homage to the false libertarian credo of choice. Any philosophical or idealogical approach to decision-making so divorced from the realities of human nature and society will inevitably lead to bad results.

    8. CommentedZsolt Hermann

      Liberal paternalism, nudging, dictatorship or complete "anarchy" are just different methods, patterns for us to try to make sense of a system we have no idea about.
      1. Since our perception of realty is totally subjective we cannot agree about a single truth, moral code, a single purpose even at home within the same family, and we have no hope to achieve any single motivator in national or international societies. Thus without some kind of "upper control" we would all be running around like headless chickens driven by our own individualistic instincts and desires.
      2. As a result we have different kinds of governance patterns trying to direct large masses of people in a single direction, but as it turns out, regardless of the actual system or culture a small minority exploits their advantage in ability, nimbleness, power, inheritance, etc and establishes a system where they can benefit from the large majority.
      3. Today we reveal how false this system is even in the most developed western "democracies", and nobody is happy, but everybody is trapped, since we still do not have the necessary knowledge, common nominator that could guide nations or the whole of humanity towards a singular purpose without trickery or oppression.
      Our only solution is first of all to raise our heads above our present subjective, introverted perception where we only care about reality as much as it is useful for ourselves, thus only perceiving a tiny fragment from the whole picture. With a more extroverted perception then we can study the global, integral, interdependent natural system we live in, and we can fully understand its governing laws. In an integral living system, as our reality, the laws are the same regardless of whether they are applied to the whole Universe, a small living cell, or microscopic particles, or a certain human society.
      After we become aware of the natural laws applicable to all of us we can start informing each and every human being about these laws, creating a knowledge base describing an absolute network with given coordinates giving us the chance to build such a human society where you do not need to force, trick or nudge anybody, since it is obvious to each and every human being which way and why we have to progress in keeping the absolute laws everybody knows. We would have full awareness of the world we live in and about our own place within.
      We are actually in the final phase of this development, as it has been revealed that humanity evolved into a global, integral system within the vast integral system of nature, and most of the laws governing such systems have already been described.
      All we have to do is to organize a global, integral education program for the whole of humanity at all levels in order to avoid the necessity of the false, unsuccessful artificial methods we have been using all through our history.