Biased Regulators

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In their book Nudge, authors Richard Thaler and Cass Sunstein advocate what they call “libertarian paternalism”: a kind of governmental choice architecture that seeks to influence the choices choosers make. This restructuring tends to rely on small tweaks to the system, recognizing that people are often biased and irrational in their decision-making.

However, a new study shines light on an overlooked aspect of bias and policy. Economist and paper author David Hirshleifer explains,

What if the choice architects are subject to psychological bias? This could come from biases of regulators, politicians, or even economists. It can also come from the psychological biases of the voters who hire and fire political agents.

Teoh and I argue that important features of financial and accounting rules and regulation are shaped by psychological bias on the part of the architects, rather than as a useful remedy for the biases of the decision makers being acted upon.  Typically the resulting regulation is far from libertarian, as well.

We call the approach to understanding regulation as coming from smart and benevolent architects `Good Rules for Bad Users.’ (Libertarian paternalism is slightly different: `Good Suggestions for Bad Users.’) We feel the other side of the coin has been neglected, that the architects themselves may be biased, resulting simply in `Bad Rules.’ (This is not to say that all regulation is bad, but it does say that bad rules will sometimes be approved.)  We call this perspective the psychological attraction approach to financial and accounting regulation.

Specifically, we argue that some forms of regulatory ideas are good at ensnaring the attention, emotions, and cognitive biases of regulators and the public. Such regulations do not necessarily help others, on the whole, and indeed may have highly perverse effects. But people are attracted to certain rules because they are superficially appealing. This point applies even to accounting rules, which have evolved over centuries through the interactions of different users. Rules concerning what firms have to expense, what they can capitalize, whether they are required to be conservative in reporting their performance—all, we argue, have been influenced by heuristic intuitions, not just economic efficiency.

The biases of regulators have been addressed before by other researchers. It’s a glaring oversight among “nudge” advocates that needs to be continually studied.