Peter Diamond on Behavioral Economics

Here's a small part of a much longer interview of Peter Diamond (23 journal pages) that is forthcoming in Macroeconomic Dynamics. Much of it has to do with his theoretical contributions, so I tried to select a section that is more general and covers an issue that has come up here quite a bit, behavioral economics. If you are unfamiliar with Peter Diamond's work, here's the introduction from the interview:

Peter Diamond is one of the major contributors to economics during the last half century. His many contributions include research on growth, Social Security, public finance more generally, the economics of uncertainty, search theory, in particular, and economic dynamics, in general. This work has shaped the way we think about many economic problems, and the way in which we formalize them. ...

In this interview, ... we tried to learn how Peter became an economist, who his influences were, and what he thinks about some of the big issues in economics. We also talked about how he started working on several of his projects, and also how and why he sometimes stopped. Interestingly, as we all know, Peter is not only one of the leading economic theorists of his generation, he also takes policy issues very seriously. A leading example is provided by his interest in Social Security. ... The entire process was a fascinating and pleasant experience for us, as interviewers, and we hope that readers get as much out of it as we did.

And here's part of what he has to say:

An Interview with Peter Diamond, by Giuseppe Moscarini and Randall Wright, Macroeconomic Dynamics: ...MD: Since we are interviewing for Macroeconomic Dynamics, maybe the readers would like to hear your comments on the state of macroeconomics, past, present, and future.

PD: I've already indicated that I think nominal stuff really matters. My other thoughts, reactive thoughts, are things that are widely held. Heterogeneity matters, uncertainty about the future matters. I am a card-carrying behavioral economist and I think that matters in both micro and macro. I became convinced that there is a lot of truth in Kahneman and Tversky's work a long time ago. I first got to know Tversky in 1969 when I was teaching in Jerusalem. I didn't meet Kahneman until somewhat later. I found that approach fascinating, plausible, and from time to time I would sit around to think about how to use it in economics, and not coming up with any way of doing it, because it is hard, and I admire the people who have made the breakthroughs and have turned it into a research community, as opposed to an anomaly that you identify and you know is something that ought to be addressed and, if you could, it would make economics better. So I think it matters in macro as well.

We also know that the competitive model doesn't describe either labor markets or product markets. We know that it's a very handy tool to use because we have a great deal of understanding of it and it contains considerable empirical relevance. It also has a lot of nice properties for helping you isolate how something you're exploring in a model impacts equilibrium, because you know what equilibrium is like without that. So, I think it's very handy. The question for any applied research with an eye on some policy issues is how important are the deviations and to what extent can you build them in. Well, tax policy is a place where they matter and we don't have a good handle on how much they matter. Macro is another place where they really matter. Before I was describing how I think about policy. I think there are things you can learn from macro models that have the underlying market-clearing, competitive, structure, but you shouldn't weight them too heavily when thinking about policy because they are missing some key ingredients. I don't know if I have anything more to say, because it's not the case that I stay abreast with macro developments.

MD: Regarding behavioral economics, what persuaded you that this is important? Is it the evidence from psychological experiments?

PD: There are two separate pieces to this. One piece is, do you think the psychological evidence is credible as a basis for thinking that people behave in ways that are missing in a standard model. The second question you ask is what makes you think that it's important to economics. Some of these you don't even need the experience to say: yes this is okay. Thaler's piece on the Price of a Bottle of Beer is a classic. Two guys are on the beach, one guy says to the other, I'm going to get myself a beer. Do you want me to bring one for you? Second guy says, Yes please. First guys asks, What is the maximum you are willing to pay for the bottle of beer? If it's higher than that I won't bring it. There are two scenarios—scenario 1 is the place to go for the bottle of beer is a bar in the hotel that's near the beach. Scenario 2 is the grocery store that has some beer in it. When you ask people how much they're willing to pay, people expect to pay more and they give answers that reflect that, so you get very different answers in these two scenarios and it can't be that they're both actually measuring what beer is really worth to you on the beach that day.

To turn it around, it's sellers who are setting prices who are very interested in these psychological phenomena, and it's not a game against nature, it's a game against people who are trying to behave on their side of the market in awareness of psychological aspects of the people on the other side of the market. So I think it matters for all sort of things. It's that view I have, that it ripples through all of economics, that had me agree to organize a conference for the Yrjö Jahnsson Foundation. The commissioned essays were thinking about behavioral issues in the context of different applied fields to stimulate applied work, not behavioral finance that doesn't need stimulus, but rather public finance, development, law and economics, health, organization theory, and some macro. We focused on how the applied fields are going to change when the behavioral ideas get adequately modeled and can influence more the way we think about policy.

We have lots of laws in this country that are built around understanding the psychology of behavior. The obvious one is the three-day cooling-off period for door-to-door sales. It's not a binding contract, you can get right out of it. You don't have a law like that if you have the rational meeting of the minds image of a contract. And, of course, in Social Security, key are the ideas that left to their own devices, people don't save enough and that people do not understand the value of real annuities enough. So Social Security has been a behavioral topic for a long time, but having formal models will refine how those insights feed into both positive and normal economics.

MD: Isn't the challenge precisely to model things properly? The skeptics describe behavioral economics as pigeon holing facts in ad hoc preferences.

PD: In behavioral economics as in every other branch of economics there is good work and bad work.

MD: But are you bothered by this aspect of the literature?

PD: First of all psychology doesn't have a unified model. Secondly, one of the main messages that comes out of this is context dependence. In fact, one of the things I don't like in some behavioral analysis is you do an experiment in one context and you act as if you can take the parameters from that and use it in different contexts. I don't think that is the case. So, the progress on getting usable implications can be very slow because one of the fundamental premises is you don't have the generalization that we are used to. This model sheds light on a certain intertemporal problem and it can carry over to a lot of other examples of problems. The heart of this is that—and this goes back to one of your earlier questions—you have to think, “What did I actually learn from this piece of analysis?” One of the things that I tell students is that it's the wrong question to ask if something is a good model or a bad model; something could be a good model for one question and a bad model for another question simultaneously. ...