## Rethinking Economics — New Lessons from Behavioral Economics

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**Canonical URL:** [Rethinking Economics — New Lessons from Behavioral Economics](https://www.imf.org/-/media/files/publications/fandd/article/2024/03/malmendier.pdf)

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### Behavioral origins and evolution
- Behavioral economics began disrupting the rational-agent paradigm in the late 1960s and 1970s through the work of Daniel Kahneman and Amos Tversky, notably prospect theory (1979), which showed people:
  - overweight minuscule probabilities and underweight likely events;
  - care about changes in relative wealth and strongly dislike losses.
- Richard Thaler and others extended these insights into finance and economics, documenting anomalies (for example, seasonality such as why stock prices tend to rise in January) and integrating psychological realism across finance, labor, public, development, and macroeconomics.
- The field evolved from identifying anomalies and psychological explanations to empirically documenting large real-world impacts and embedding behavioral insights into mainstream economic questions (for example, why profitable agricultural investments can have low take-up).

### Mind, body, and neurobiological foundations
- Recent behavioral research emphasizes that humans are living organisms whose biology and life histories matter: neuroplasticity causes brain pathways to strengthen or be pruned by experience, producing persistent changes in beliefs and decisions.
- The “computer with flawed software” metaphor is insufficient: life experiences can rewiring people’s preferences and risk-taking in lasting ways that affect financial, labor, and other economic behavior.

### Experience effects — definition and characteristics
- Experience effects formalize how personal lifetime experiences influence beliefs and decisions in a lasting way, challenging models where agents use all available information symmetrically.
- Four key features of experience effects that influence policymakers and laypeople are exactly the same:
  - The long-lasting effects of experience
  - Greater weight on more recent events
  - Domain-specific experience effects
  - The negligible effect of learned knowledge vis-à-vis experience-based beliefs, however distorted

### Empirical evidence and domain specificity
- Historical examples:
  - Those who grew up during the Great Depression (“Depression babies”) were extraordinarily frugal and averse to stock-market risk; only 13 percent invested in the stock market at all—less than half the rate of any later generation.
  - East and West German comparisons: living under communism left lasting distrust of the stock market; those who had relatively good lives under communism were often the most adamant about the harms of the stock market, whereas those who suffered under the regime were more likely to embrace post-communist market opportunities.
- Domain specificity:
  - Experience effects are domain-specific: stock market experiences influence stock investment but do not seem to affect bond market investment.
  - Experiences in one domain (for example, grocery shopping exposure to food-price volatility) explain gender differences in inflation expectations: women who are primary grocery shoppers have higher inflation expectations than male partners, consistent with food prices experiencing higher inflation or higher volatility.
- Policymaker examples:
  - Federal Reserve Board of Governors’ inflation forecasts tend to be biased toward their lifetime experienced inflation and away from expert analysts’ forecasts, reducing forecast accuracy.
  - Henry Wallich, raised during 1920s German hyperinflation, dissented 27 times as a Federal Reserve governor because he prioritized concern about inflation.

### Mechanisms and behavioral implications
- Mechanism: individuals weight outcomes they have personally observed more heavily when forming beliefs under risk; recent events receive greater weight relative to older events, but only within the individual’s lifetime experience set.
- Generational effects: a 60-year-old and a 30-year-old will respond differently to the same financial crisis because the crisis comprises a different share of their cumulative life experiences.
- Emotional valence matters: emotional experiences (positive or negative) can intensify or counteract domain-specific beliefs about markets or policies.

### Policy implications and recommendations
- Crisis management:
  - Because experience effects are long-lasting, policymakers face a trade-off between resolving crises quickly and the cost of doing so; shorter and milder crises cause weaker long-term scarring, while more traumatic experiences have longer-lasting effects.
- Targeting and tailoring:
  - Policies should account for heterogeneity in lifetime experiences across country-age-gender cohorts; identical interventions may elicit vastly different responses depending on past exposures.
- Use of experiential interventions:
  - Experience-based learning can shape policy support more effectively than purely informational approaches. Direct engagement, such as pilot interventions, can change preferences substantially.
  - Example: under the Affordable Care Act (ACA) in the United States, individuals on government health insurance who had direct, immediate benefits were more likely to support the ACA; initially skeptical Republicans were especially likely to become supporters, illustrating how experience can overcome partisanship.
  - Policymakers can deploy pilot programs to generate positive personal experiences that foster enduring public support.

### Key statistics and concrete findings (as reported)
- Only 13 percent of those who were teens and young adults during the Great Depression invested in the stock market at all—less than half the rate of any later generation.
- Henry Wallich dissented 27 times as a Federal Reserve governor.

*Ulrike Malmendier and Clint Hamilton, Rethinking Economics, MARCH 2024, F&D. Ulrike Malmendier is a professor of economics and finance at the University of California, Berkeley, where Clint Hamilton is a PhD student in finance at the Haas School of Business.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2024/03/malmendier.pdf_