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MIND THE GAP: RECONCILING THE THEORY AND PRACTICE OF

ECONOMIC POLICY MAKING
Introduction
This short paper aims to answer a simple but fundamental question: why is it so difficult for
policy makers to reach economically rational decisions? Yes, many politicians consciously
or subconsciously gravitate towards solutions that they think will win them votes. But the
issue is a bit more subtle than that, involves some fundamental insights about human
nature and raises some challenging questions for the technocrats advising politicians.
This paper is by no means a comprehensive discussion, merely a perspective providing food
for thought.
Theory: economic efficiency and cost-benefit analysis
In the UK, the ultimate authority on the economic advice that should be provided to
decision makers is the HM Treasury Green Book. Broadly speaking, the guidance is not that
different from the practices that are well-established in the private sector: work out the
return on investment of various different options under various different scenarios and pick
those projects with the best expected bang for buck. Allocating constrained resources in
this manner should optimise the economic benefits available.
Practice: real world constraints and political economy
There are countless examples of decisions, however, that violate the above rule. Indeed, it is
my (impressionistic and admittedly exaggerated) experience that the ideas most liked by
politicians tend to be precisely those that seem to yield the lowest return on investment, or
at least suggest lower net benefits than viable alternatives.
For example, in transport, investment in trams and rail seem universally more popular than
investment in roads or buses. Yet, on average, the latter yield better benefit-cost-ratios
1
. In
energy, (often much cheaper
2
) imported fuel is somehow seen as inferior to homegrown
sources, such as electricity generated from wind or biomass. Despite evidence
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on its
ineffectiveness, successive governments have insisted on spending money trying to
regenerate declining geographic areas. Helping small businesses is seen as a priority, even
though very few of them generate new, productive jobs and growth
4
.

1
See for example The Eddington Transport Study, The case for action: Sir Rod Eddingtons advice to
Government
2
See for example Electricity Generation Costs 2013, Department of Energy and Climate Change
3
See for example Local development: for people, not places, ESRC evidence briefing
4
See for example Future champions: Unlocking growth in the UKs medium-sized businesses, CBI and The vital
6 per cent, NESTA
2

There are several plausible explanations for these patterns, all of which are no doubt a
factor in what takes place:
1. Unknowable costs and benefits: In practice, when trying to estimate the costs and
benefits of any particular intervention, there are many variables that are simply
impossible to quantify robustly. Most importantly, by definition, there can be no
evidence about the future. Therefore, a large element of judgement is inevitably
involved, which reduces the power of cost-benefit analysis to persuade.
2. Broader considerations outside the cost-benefit framework: The Green Book and
good practice on cost-benefit analysis allows plenty of room for more qualitative
considerations, such as for example sustainability, well-being and fairness. However,
because these wider considerations can be argued to be beyond technical analysis,
politicians may see it as their mandate to give their own personal judgement on such
matters a higher (implicit or explicit) weighting in decision making.
3. Optimising votes, not economic outcomes: It is of course possible that the ultimate
decision makers have a different objective function to that of the technocrats
advising them. Rather than optimising economic or social net benefits, maybe
decisions are most swayed by factors that politicians think are most likely to deliver
most votes at the next election. Maybe they even believe that this is what
democracy is all about. More on this below.
4. Polarised choices today: Imagine a venn-diagram with two circles: one representing
the economically sensible policies and the other the politically attractive ones.
Maybe at some point in history, there were plenty of ideas in the middle of the
diagram, where economics and politics concur. For example, a minimum wage would
fit this category
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. But maybe most of these ideas have now been taken up. So,
politicians are increasingly faced with a choice between economically rational but
unpopular options and ones with fewer economic credentials but intuitive appeal.
Given that the economics can never be proven conclusively, perhaps it is
understandable that they often prefer the latter.
Do cognitive shortcuts explain some of the mismatch?
In my observation, life is not quite as simple as the above would suggest. In particular,
whether consciously or not, decision makers seem to be motivated by at least three rather
different drivers: yes, there is pure self-interest (votes at the next election); and indeed,
there is selflessness (doing whats in the best interest of Britain); but there is also the
democratic mandate. Having been elected to power, it is the job of politicians to represent
their electorate. And members of this electorate differ in some very important ways from
the homo economicus that underpins the assumptions in cost-benefit analysis.

5
See for example The UKs National Minimum Wage, Centre for Economic Performance, LSE
3

The notion that real human beings are not perfectly rational has become mainstream in
recent years, partly due to popular books such as Thinking, Fast and Slow by Daniel
Kahneman, Nudge by Richard Thaler and Cass Sunstein, and Predictably Irrational by
Dan Ariely. As psychologists and behavioural economists have catalogued human behaviour
and run experiments, the evidence has mounted that rather than the perfect logic of a
super-computer that can analyse the cost-benefits of every action
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peoples behaviour is
guided by the use of cognitive shortcuts things like intuition and heuristics.
A Wikipedia entry lists almost 100 such shortcuts, but a more accessible account can be
found in the excellent UK government document MINDSPACE or the more check-list-like
document I produced while working on innovation. The chart below picks out a few key
examples of the type of preferences people tend to have that might well explain the gap
between the technocratic and political economy view of the best policy options to pursue.


So, to put it really simplistically, people in general dont actually seem to prefer
economically optimal policies. No wonder, then, that recommendations based on cost-
benefit analysis often do not feel right to elected politicians.

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Quote from MINDSPACE: Influencing behaviour through public policy, Cabinet Office and Institute for
Government
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Next steps: the role of the technocrat
So, should the civil servants who advice decision makers base their recommendations on
their best judgement of what is economically and socially optimal or on what people
actually want? Many would certainly argue the case for libertarian paternalism
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: influencing
choices in a way that will make choosers better off, as judged by themselves (but often after
the fact). This view explicitly recognises that what people want (e.g., chocolate) and what is
best for them (e.g., vegetables) are two different things.
By and large I subscribe to this view: technocrats should recommend what is best for the
nation, even if this is not very popular. It is then up to the elected politicians to make the
judgement calls on how to balance peoples wants and desires with what is best for them.
This view does, however, raise the bar very substantially on how economists and others
arrive at their views about what is best for people.
There are at least three ways in which practice needs to be improved. Firstly, because of the
large element of judgement involved in any cost-benefit analysis, those formulating
recommendations must be real experts in the subject matter. Secondly, a much more
sophisticated view of what makes people better off needs to be adopted
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. Thirdly, we need
to examine and evolve how we define rationality: sometimes, risk-aversion or short-termism
turn out to be perfectly rational, even in todays world
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.
Tera Allas
5 September 2014



7
See for example Nudge by Richard Thaler and Cass Sunstein
8
See for example Wellbeing and Policy, Legatum Institute
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It is likely that the cognitive shortcuts have been shaped by evolutionary forces, so they have certainly been
rational at some point in the history of humans.