Behavioral Economics and Institutional Innovation

Abstract

1. IntroductionI wish to talk today about how economic research leads to fundamental innovation in our economic institutions, institutions such as our social welfare system or our financial infrastructure. This topic is really about how economic research contributes to welfare since so much of what helps humanity in the long term from economics comes from a change in our institutions.In this context the major theme I wish to address is the importance of behavioral economics in bringing economic ideas to successful results. Behavioral economics is really the application of methods from other social sciences--particularly psychology--to economics. Behavioral economics is central to institutional innovation because it rounds out the details, the frictions or imperfections that might make some grand idea for a new economic institution unworkable if not appropriately dealt with.A related theme that I wish to cover is to try to say something useful about the centrality and the difficulties of the inventive process that underlies institutional innovation and its essential similarity to invention. The invention of economic institutions is not unlike inventions: It must deal with a multitude of problems and obstacles, including the problem that the people who must use the invention are themselves imperfect. What engineers call human factors engineering is especially important in the invention of economic institutions. As with inventions, the breakthroughs, the discoveries of new economic institutions, tend to be infrequent, sudden, and dramatic. Once an invention of an economic institution is made, it tends to be copied all over the world.In the course of considering these themes, I will also make three subsidiary points: that institutional innovation requires a motivated and enthusiastic level of scholarly discussion of economic innovation, that a sense of economic crisis may often propel such discussion, and that advances in information technology are often behind major advances in economic institutions.Some of these themes were discussed in my 2003 book The New Financial Order: Risk in the 21st Century, which also included a number of proposals for new risk management institutions. But here I will focus on developing the basic ideas about institutional innovation further in the context of social insurance and with special attention to the role of behavioral economics.In this talk I will consider a little history of thought in both fields, behavioral and institutional economics together, from the perspective of their contribution to some of our most important social welfare institutions, institutions that help people manage the risks of living. I will trace the interaction of practical policy with economic thought extending back to the beginnings of modern social welfare institutions in 19th-century Germany up to the present. The example of the invention of workers' compensation will be particularly stressed, as it affords a perfect example of the interplay between economic theory and behavioral economics in producing fundamental economic innovation. I hope this will offer some insights into the way that progress is made in economic policy through the interaction of economic thought and the experimentation of social policymakers.2. Behavioral EconomicsWe divide the social sciences according to subject matter but also according to method. We might define the field of economics in terms of subject matter as the study of prices, quantities, resource allocation, and economic organization. But we might also define the field of economics as it mostly exists today as a certain approach to social science, an approach that is based models of rational optimization and, in particular, of individuals' maximizing an expected utility function.Unfortunately, the division of the social sciences by subject matter does not neatly match with the division according to method. …