Regular readers will by this time be familiar with Behavioral Economics, the discipline that I am currently pursuing a Master’s Degree in at the University of Nottingham.

Quick recap: Behavioral economics is (mostly) about consumer behavior, studying it without the assumption that consumers are rational (an assumption made by “regular” economists). Instead, we look at issues such as: Why do consumers not save enough for retirement? Why do stock market crashes and panics occur? How do behavioral biases affect our economic decision-making?

Most behavioral economists use their findings to advocate for more government intervention: Surely, if consumers aren’t rational, then Big Brother has to step in and make sure they don’t hurt themselves. Kind of like how a kindergarten teacher has to intervene whenever a kid wants to run around with scissors – you have to do it for their own good.

Personally, I feel most behavioral economists are kind of like Columbus: They discover something big, but has NO IDEA what it is they actually discovered. Columbus thought he had discovered a small island in the west indies, behavioral economists think they’ve discovered the inherent flaws of a free market.

Basically, this stems from the fact that most behavioral economists will limit their analysis and conclusions to private investors and consumers. They tend to forget that governments consist of individuals as well – who can be just as irrational or more, than individuals outside of government.

Now, onto today’s topic: The deficit.

I’ve previous explained how deficit spending is dangerous as it can become a habit – what was supposed to be a short-term deficit becomes the new normal. However, behavioral economics has more to offer when it comes to explaining deficits.

In particular what I’m going to try and explain in this post, is why we don’t just cut the deficit before it gets so large. Why don’t we simply make the necessary cuts and get over with it? Why didn’t we do this ages ago? Why are politicians always talking about “growing away the deficit”, when they know that the likelihood of that happening is close to zero?

The reason can be summarized in two words: Prospect theory.

This is a theory that (to simplify) states that individuals are risk-averse when it comes to gains, but risk-loving when it comes to losses.

That didn’t make you any wiser? OK, let me explain – it isn’t that complicated. Basically, if you have to choose between 100 dollars or a 50 % chance of getting 200 dollars (and 50 % chance of getting nothing), then you’ll most likely pick the first option and get 100 dollars with 100 % certainty.

However, if you have to choose between LOSING 100 dollars, or losing 200 dollars with 50 % certainty and losing nothing with 50 % certainty, most people will go with the second option; basically, we’re willing to gamble in order to try and avoid certain losses, but we’re not willing to gamble to try and increase a certain gain.

This is very typically seen among poker players: You bet more aggressively after losing, hoping to recover your losses. But, if you already have more chips than anyone at the table, you’ll play more passively (risk-averse), guarding your gains.

What does this have to do with deficits? Think of the deficit as a loss. Now imagine you’re a politician who can choose between cutting the deficit (losing 100 dollars with certainty) or increase up the deficit even further in an attempt to stimulate the economy – and if the stimulus program is successful and high growth returns, then there might just be a chance that the government could “grow away” the deficit and avoid those painful budget cuts (the equivalent of choosing $200 loss with a probability of 50 %, and 0$ with a probabilty of 50 % – though obviously, the probability of a stimulus program being successful is much lower than 50 %).

Basically, when a government is faced with a deficit, they have two choices: Bite the bullet and cut the deficit now, or “double down” and face a gamble with two possible outcomes: Either, you’ll end up with an even bigger deficit, or with no deficit at all.

When the government decides to conduct stimulus programs, they are choosing the gamble.

Now what is the problem? Loss aversion (as the phenomena is also known as) is not in itself irrational after all – it’s just something that is not predicted by standard economic theory.

The problem is, as any poker player will tell you, that the more you lose, the more willing you will be to gamble even more to try and recoup your losses. Basically; don’t count on the government to stop gambling with stimulus programs just because the deficit keeps growing.

Obviously, the deficit is not the only example of this – there are indeed thousands of examples when the government will “double down” on a failed policy rather than to change the policy and save what can be saved. Part of the reason may be pride (another phenomena studied by behavioral economists), but part of the reason is definitely that when a loss is all-but-guaranteed, we act differently and go into “gambling mode”.

What’s the lesson from this? At first glance, this looks like a pretty hopeless situation: The more deficit we get, the more gambling we get, and the bigger the deficit will become. There really isn’t any “cure” for this kind of behavior – so the situation is tricky to say the least.

The one thing that we can change however is our rhetoric – the way we frame the issue. Basically, conservatives need to frame this issue as a choice between possible gains, not one of losses: If we take the safe path of balancing the budget now, then we will gain a stable economy, a prosperous business environment, and remain the world’s leading superpower. If we choose t gamble and increase the deficit today (hoping that by stimulating the economy we can make it fall tomorrow), then sure, we might end up in an even better spot in the first scenario (balanced budget + no painful budget cuts) – but there is also a huge risk that we’ll lose everything and end up having to cut even more at a later point, and then at that point even balancing the budget might not be enough.

You just have to remember that individuals are willing to gamble with losses, but not with gains. So if you want to discourage gambling in any given situation, frame the alternatives in terms of gains.

That’s it for today. In my next post, which I hope to have done this weekend, I will talk about the sequester from a behavioral economic point of view, so stay tuned. Thanks for reading.

Photo credit: Xampl9 via Flickr (CC-by-NC-ND 3.0)

  1. You make an extremely important point that government leaders are no more likely to behave rationally than anyone else. Noting that stimulus is a gamble is also spot on. But austerity may represent a similar gamble. In the belief that “biting the bullet” will solve all of our economic problem, a global depression could result. When our other economic crisis, the unsustainable demands on the Earth and its natural systems, is included in the debate, we may have maneuvered ourselves between a rock and a hard place.

    1. Michael, first of all, thanks for your comment. It is true that austerity is not certain to work, but in a study by Reinhart & Rogoff they found that among (formerly) highly indebted countries who had managed to reduce their government debt significantly (by 25 % or more). Nearly all of them (I think it was 17/21) had used austerity to reduce their debt – basically, painful as it is, austerity has a good record.

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