Some thoughts on behavioral economics

It has been an interesting conference on behavioral finance here in Portland.  I’ve had an opportunity to think about this subject for the the first time, listen to some ideas about specific legal applications of behavioral finance from Steve Choi, Jill Fisch, Don Langevoort and Adam Pritchard, get general observations on the field from Henry Manne and my colleague Tom Ulen, and then wash it all down with, by my rough count, 20 different wines, mostly from Oregon, at some very beautiful wineries, capped with a fantastic meal here.  More about the wine -- or more precisely the wine business -- in another post. 

Henry and Tom did a good job putting the field in perspective.  Although they didn’t do this deliberately, they ended up responding to the question the conference organizers posed – is behavioral finance instruction or distraction? 

Henry, in effect, talked about the “instruction” of behavioral finance. He pointed out that behavioral economics is just the latest in a long line challenges to market theories that were supposed to demonstrate why we shouldn’t rely on markets. But, says Henry, they have done nothing of the sort.  Instead, they have challenged us to think more deeply about and, in the end, enrich market theory. 

With respect to behavioral finance, Henry pointed out that, as Hayek said, markets work quite well despite the limited information and defective judgment of their individual participants.  When markets do go awry, it often may be not because of some inherent problem, but because they’re not allowed to operate freely.

So, for behavioral finance, legal rules may inhibit or impose costs on trading that could correct the mistakes that individuals make.  We restrict trading by the insiders who have the most information and, as Henry observed, have the most effect on prices.  We also restrict short-sales, limiting the extent to which prices can correct on the downside.  Now there are moves toward regulating hedge funds, which can also act as powerful market correctives.

Tom Ulen implicitly addressed the distraction side.  Lawyers, he pointed out, not having a developed science of their own, borrow, sometimes uncritically, the science of others.

Tom didn’t have time to develop this point, but I have my own thoughts along these lines. The question for lawyers and legal academics about behavioral economics and behavioral finance is, of course, how all should this matter to law. This requires us to understand the capabilities and limitations of law. 

How might a developed legal science get us to better legal responses to behavioral finance?  As I discuss in my contribution to the conference, Fraud on a Noisy Market, it might give us some insights about what courts and regulators are able to do, in light of their limitations. Our hubris and bias favoring legal solutions led us to assume that we understood financial markets well enough to regulate them through a single mandatory, perpetual, federal law.

Now behavioral finance should teach us some humility.  Behavioral finance might be saying that disclosure doesn’t have the effect we thought it did when we assumed markets were efficient.  Or, as I argue in my paper, we should be careful in assessing the damages supposedly done by misrepresentations.  Or, to go back to Henry’s thoughts, we should hesitate to impose other regulation that limits markets’ ability to self-correct.   

All of this thinking could lead us to what I’ve called “humble regulation.” See my paper, Sarbanes-Oxley after Three Years. I discuss a particular brand of such regulation in my paper for this conference – a greater reliance on state law. Similar observations apply to the topics covered in other papers for this conference – Choi on regulation of initial public offerings, Fisch on securities analysts, Pritchard on auditors, and Langevoort on scienter and other aspects of the Martha Stewart case. In many of these cases, particularly including auditor regulation, simply enforcing private contracts might be the way to go.

Anyway, these are some quick thoughts for now.  We’re off soon for the Oregon coast. . .