The Trouble with Libertarian Paternalism

A clear example is financial regulation, which in many ways is a form of paternalism. In the US, the low risk assigned to senior tranches of mortgage-backed securities made them attractive instruments for banks to hold, given the relatively high return they offered. But they proved far from safe, despite the prior conventional wisdom. And, because the regulator had pronounced them safe, far too many banks overloaded on them, rendering them even more risky when the banks tried to sell them at the same time.

Other examples of the danger of the coordinating power of government paternalism abound. As I drive to downtown Chicago, I pass a series of high-rise housing projects, meant in their time to be the miracle cure for homelessness, poverty, unemployment, and crime. Today, they are seen as the best way to concentrate and perpetuate many of those ills.

Not only were the housing projects kept a safe distance from areas that had good jobs, but, with few residents experiencing stable families and livelihoods, there were not enough local examples of success to guide young people. As a result, many went astray.

The fashion today is to integrate poor households into flourishing communities. No doubt we will discover some unintended consequences in the future, and the power of government coordination will ensure that those consequences are widespread.

But some amount of paternalism is necessary in civilized societies. Social security is a paternalistic form of forced savings for old age, preventing individuals from consuming and saving as they please. It exists, in part, because individuals know that civilized societies will never stand by and watch the elderly starve. So individuals are forced to save in order to prevent them from gaming the system – not saving when young, knowing that they will be assured a minimum level of support by a humane society when old. Similarly, the mandated purchase of insurance in the Obama administration’s health-care bill is an attempt to prevent the young and the healthy from remaining uninsured and turning to the government for support only when they discover that they need it.

So, if paternalism has benefits as well as costs, how do we get the former without the latter? My colleague, Richard Thaler, along with Cass Sunstein, who currently serves in the Obama administration, wrote a best-selling book, Nudge, in which they suggest a way to reduce our uneasiness with paternalism. Essentially, by exploiting behavioral quirks, they would nudge people into making decisions that are good for them, even while individuals have complete freedom to change their mind. So libertarian paternalism, in their view, eliminates one of the main objections to paternalism – that it constrains individual choice.

For example, in deciding how their pension savings will be allocated, most people simply choose the default option in their employer-offered plan. Often, the default option is unsuitable for most individuals – for instance, it typically allocates all savings to low-return money-market funds. Sunstein and Thaler would have the employer choose a default option that works for most people, such as 60% in equities, 30% in bonds, and 10% in money-market funds.

That is the paternalistic part. The libertarian part is that the employee has the right to opt out of the default option. Because people rarely move away from the default option, the employer’s paternalistic choice prevails, and we get libertarian paternalism. What is not to like?

The problem is that the semblance of choice in libertarian paternalism is an illusion. Choice remains unexercised, because individuals do not consciously think through their decision. If their choices can be directed, is this not paternalism plain and simple, rendered more sinister because individuals are unaware that they are being nudged, and cannot raise their guard?

One response is to point out that most plans already have a default option that determines savings allocations. Sunstein and Thaler merely say that the default option should be set in a way that is good for people, and clearly they have an idea of what is good.

This, then, is the nub of the problem. In choosing the default option, the government or the employer nudges all employees into prevailing fads such as “buy equity for the long run.” This, they believe, is better than the current typical default option of putting individuals’ money into money-market funds. But it may be worse: coordinating everyone into risky asset investments may be more dangerous than coordinating them into boring investments like money-market funds.

Could there be a better alternative? What if there were no default option, and individuals were sent repeated, and increasingly urgent, reminders to choose an allocation if they did not choose one already. The conventional wisdom could be offered as a recommendation, along with explanations of why it makes sense, but it would not be the default. This would force people to exercise choice. Some people would differ from the conventional wisdom, benefiting the system by introducing some variety and resilience.

More generally, the flaw in some forms of libertarian paternalism is that the free choice that it appears to offer leaves the paternalism largely unconstrained. Would it not be far better to force conscious choice in order to limit the consequences of paternalistic mistakes?

Raghuram Rajan is a professor of finance at the University of Chicago’s Booth School of Business. He previously served as the International Monetary Fund’s youngest-ever chief economist, and was Chairman of India’s Committee on Financial Sector Reforms.