Peter raises the threat that behavioral economics poses to free market policy. I’m less concerned about this movement, in large part because its teachings can be turned against central regulators.

Here’s law professors Stephen Choi and Adam Pritchard, from the conclusion to their excellent 2003 article Behavioral Economics and the SEC (from the Stanford Law Review; working paper version available here):

Regulators are vulnerable to a wide range of behavioral contagion. Regulators may suffer from overconfidence and process information with only bounded rationality. Heuristics play a large role in how regulators make decisions. Even with expertise, regulators may misapply heuristics across the spectrum of different regulatory problems. Regulators may also suffer from confirmation bias, supporting prior regulatory decisions whatever the wisdom of the decisions.

And in groups the decisionmaking of regulators may decline rather than improve. On the one hand, groups and organizational structures may help alleviate some of the mistakes that derive from individually biased decisions. Studies of group decisionmaking provide evidence that the total can indeed be greater than the sum of individuals in enhancing the accuracy of decisions. But cognitive illusions may grip entire groups. Groupthink may also lead to an uncritical acceptance of regulatory decisions.

If both investors and regulators operate under the influence of behavioral biases, the value of regulation in correcting these biases comes into question. If regulators are not well equipped to determine whether regulation will counteract the biases facing investors, regulation may well do more harm than good. Worse still, SEC regulators may suffer greater behavioral biases than securities market participants. Investors that perform poorly will either learn (and perhaps put their money into an index fund or otherwise hire expertise) or exit the market. Private institutions face similar market pressures to serve the interests of their client-investors or perish. Although some types of biases may give institutions a competitive edge, the magnitude of such biases is limited by the cost that they impose on investors. The market may not function perfectly, but regulators under the present regime face no such pressures.