Economic Applications

Causal Economics—the New Frontier of Behavioral Economics You Should Know About

Why Doesn’t “Regular Economics” Work?

The expected utility approach to economic decision making that many of us learned in school quite simply doesn’t explain human behavior. It’s built on the assumption that people are 100% rational. But as we know, people are often emotional and irrational. The recent surge in popularity of behavioral economics came about to fill this gap. It’s done a great job—but it hasn’t gone far enough. Expected utility and behavioral economics both generally model decisions based on single period time horizons and reactionary response to random outcomes. That’s not even close to reality.

Real world decisions require upfront effort—money, exertion, commitment etc. That is certain. They also require time for benefits to result, and those results are not always fully certain. Think of losing weight, making investments, building a business, pursuing a desired mate, supporting the environment etc. All of these real world decisions we make cover multiple periods, involve upfront costs and hopefully produce subsequent benefits.

Causal Economics Can Help

Causal economics is a new stream of behavioral economics that effectively models these real world decisions. It’s built on the central concept of causal coupling. Causal coupling models decisions as requiring deliberate upfront cost (psychological and/or financial) in anticipation of future uncertain benefits (psychological and/or financial), with sustainable/Pareto Optimal outcomes possible when all impacted stakeholders experience a gain in benefits relative to costs (i.e. a Causal Coefficient, X ≥1) or face zero impact. Another unique feature of causal economics is that the utility function is optimized against internal personal psychological trade-off constraints, not just traditional budget constraints. Due to its robust framework, causal economics can effectively model a full range of psychological factors that currently get loosely attached to the core analytical framework of behavioral economics—cumulative prospect theory. These structural features of causal economics allow us to model all decisions, not just ‘economic’ ones.

Causal Economics is a Unifying Theory of Economics

Causal economics is a unifying theory of economics because the other mainstream models of economics can be derived from it mathematically. To reduce causal economics to behavioral economics and expected utility, various restrictions to independence assumptions are made, and cost and benefit (deliberate and uncertain) are collapsed into a single time period and single outcome value.

Macro Implications

The principle of causal coupling at the center of causal economics provides a simple and consistent tool for analyzing macroeconomic environments. It asserts that results will be Pareto Optimal and sustainable when all impacted stakeholders experience a gain in benefits relative to costs or no impact at all. That happens when a policy results in a Causal Coefficient (X = change in benefits/change in costs) greater than or equal to one for all stakeholders. Essentially all individuals are able to enjoy the benefits that result from the costs they incur and bear the costs of the benefits they receive. At a macro level, causal coupling can be thought of informally as ‘freedom with accountability’.

The example applications below demonstrate how causal coupling can consistently yield fresh theoretical insights into important macroeconomic issues based on cost and benefit incentives that contain financial and psychological elements. They are by no means intended to be comprehensive and fully pragmatic treatments of each topic in all real world applied situations. But there is a good chance they will challenge the assumptions many have about effective economic policy.

From a theoretical perspective, causal economics asserts the importance of an engaged democratic majority, optimality of free competitive markets with corrections for externalities, fair legal frameworks in place of government bureaucracies, minimal monetary and fiscal policy, valuefare (workfare with chosen work hours) and taxes collected for specific voter-approved spending programs instead of being automatically collected and fed into general accounts based on income, consumption, property and wealth.

Engaged Citizens

Pareto optimality is only possible in a democracy where a majority of citizens are engaged in free and open-minded discourse and action. The values and goals of society will reflect the will of engaged citizens—whether they’re in business, government or other social organizations—and whether they’re leaders or everyday people. The policies and structural elements noted below can only serve to efficiently and fairly meet the goals that citizens set for their society.

Free, Competitive Markets

The free market is the ultimate causal coupling mechanism because participants voluntarily couple cost and benefit. Buyers select what cost they are willing to pay (price) to obtain desired benefit from the purchase. Sellers part with a good/service that they incurred costs to provide, but in exchange they receive the selling price as their benefit, which they can use in ways that they perceive as higher value. The buyer and the seller each feel X > 1 as a result of the transaction. It’s a win/win and aligns to freedom with accountability. When markets are not competitive, concentrated power creates a breakdown in causal coupling and Pareto optimality through an involuntary shift in cost and benefit across stakeholders.

Transaction Externality Taxes

Due to their limited context (transactions), unfettered free markets can have negative broader consequences, but these are correctable. Externalities to transactions such as environmental damage can be counteracted by offsetting fees, either levied against the consumer or against the producer and passed on to the consumer. But there must also be a transparent and viable mechanism in place to deploy the collected funds in corrective action. As long as solutions start with free markets, externality taxes based on the will of an engaged and educated democratic majority followed by viable corrective mechanisms can preserve causal coupling and produce Pareto optimality.

The Role of Government

Causal coupling implies that the role of government should be to establish and enforce fair frameworks that maximize the freedom of citizens, support the most vulnerable and ensure a level playing field, where all bear their share of costs and can access opportunity. As governments generally spend other people’s money that’s automatically collected through taxes, they’re not efficient being in the business of ‘doing’. Government bureaucracies decouple cost and benefit across taxpayers and government intermediaries. Causal economics supports small governments and very clear legal/policing frameworks in their place. Even when it comes to large infrastructure projects, causal coupling suggests that government should establish a fair and appropriate framework in line with voter desires and collect specific funding via flat/user fee taxation. The actual service delivery should be through a competitive private contractor subject to the governing framework. These 3P (public, private partnership) arrangements are the best way to meet the needs of citizens broadly in the most Pareto Optimal sense possible, as they maximize coupling across all involved.

Public Services, Taxation and Debt

Causal economics doesn’t make a statement on the overall level of taxes that should be paid, other than that it should result from the will of the democratic majority based on desired programs. But it does make statements on the way taxes should be collected to deliver Pareto Optimality and preserve freedom with accountability. The model does indicate that in theory taxes should only be collected for specific purposes that a democratic majority has endorsed in advance and that these costs should be allocated across all that benefit as a flat tax. Policing, military, emergency medical services, social safety nets, power grids etc. are all examples of such core public services. Where those that directly benefit from voluntarily using a public good/service are identifiable, such as a toll bridge, they should incur their proportionate cost to provide it, through a user fee tax. Those that use services pay for them. Those that do not don’t.

Any other methods of taxation other than flat taxes or user fees result in involuntary redistribution benefiting some at the involuntary expense of others, reducing Pareto Optimality and economic freedom. From a theoretical perspective causal economics does not support the automatic collection of income, consumption, property and wealth taxes that get fed into general accounts, since these just fill government coffers with no obligation to produce results. Imagine a private company that was allowed to take part of your pay cheque before you get paid, for an amount they determine, and then decide what services should be provided to you after the fact. Not many people would tolerate that, but it’s taken as perfectly normal in government.

If a democratic majority politically desires that citizens that have more based on their economic success should take on some of the equal-share costs of others to pay for an initiative, then those additional levies should be applied transparently to support a particular approved policy. Even though involuntarily applied, this can actually increase Pareto Optimality at some levels, as those with means often want to contribute a higher share because they have been so fortunate. But from an economic theory perspective, causal coupling is clear that citizens shouldn’t be automatically taxed more to fill government coffers because they are successful and have more. Just as a ‘vote is a vote’ in politics, in general a ‘citizen is a citizen’ when it comes to contributing their core share to the cost of government programs.

Causal Economics sheds uncommon insight on some contemporary public entitlement programs such as pension plans. Many pension plans are setup where current workers fund current retirees. This is a decoupling of cost and benefit. Current retirees on pension should have paid in to cover themselves, not rely on subsequent generations. Each generation should save for its own retirement, not dip in to the efforts of other generations. This is simply an unfair and non Pareto optimal shift of some cost relative to benefit. It’s the same reason that long-term government debt should be avoided wherever possible when it provides current benefit and transfers the cost of delivering those benefits to citizens that didn’t opt for them.

Social Safety Net

Any advanced society should have a social safety net for citizens facing hard times that provides the necessities and an opportunity to contribute to society like those actively employed. Social safety nets should tie benefits to continued effort wherever possible to keep incentives aligned and minimize long-term dependence. Causal economics implies that to optimally couple benefits and costs, social safety net programs should allow recipients to work their choice of hours (subject to a minimum) deciding how much they want to work and how much they will receive (valuefare). Some public service tasks can be utilized for participants in such a valuefare system, replacing the need for those particular activities to be provided by career bureaucrats. Additional support, such as childcare, may be required to enable work participation by low income parents. Tax relief social assistance may also be required for lower income citizens that can’t bear the cost of their flat tax allocations for societal goods/services.

Poverty holds unique challenges, in that social safety nets must provide the basics of survival and also assistance with the deep personal and social challenges that can come with poverty. Only on a secure foundation like this can access to successful mentors and greater access to opportunity resources then help over time. This approach maximizes coupling. Causal economics does not support universal basic income approaches, because income can only be tied to economic output, not involuntary government redistribution. When a social safety net is required it should be provided to those that truly need it, not others that can contribute to output and earn income.

Public Risk Sharing

Employment insurance and healthcare are examples of public risk sharing programs where Causal Economics provides additional clarity. Employment insurance shouldn’t replace responsible short-term savings. These programs are funded by active working professionals, paying in premiums in case they are the unlucky one that finds themselves unemployed for an extended period. Some employment insurance programs allow for retraining, but in many ways, this is not an insurance element, so only some basic transitional support should be provided. Retraining is a cost the recipient should still bear personally over time as it is a personal investment, not tied to current unemployment.

In healthcare, every citizen should have access to life saving medical services and pay a flat share of tax each year to cover this infrastructure—as most citizens will not need such services (benefit) all the time, these taxes essentially serve as an insurance premium (cost). If any citizen can’t afford their share of these costs, the social safety net should ensure their share is covered. For elective medical procedures, user fees should be collected in order to couple benefit and cost. Either the person benefiting pays or someone not benefiting pays. Only the latter is Pareto Optimal. If a person cannot afford important elective procedures, the social safety net may need to provide important support. Keep in mind that when income, consumption, property and wealth taxes are replaced with program-specific funding taxes, extensive new budget room can exist for costs to be properly coupled to those that benefit. Surcharge taxes can be applied to those that voluntarily increase their risk/cost—such as smokers.

Monetary and Fiscal Policy

Monetary and fiscal policy can both impact national income accounting in the short term, but they are not based on voluntary exchange. Each ends up as an involuntary wealth transfer. Fiscal policy results in the government picking winners (gaining benefit) and losers (bearing cost). Even though government spending shows up in national income, it is not the same as private sector spending, because it’s not voluntary and often doesn’t provide services that the private sector would have provided in the absence of the government spending. Monetary policy transfers wealth from the poor to the wealthy (asset holders), through price inflation. The purpose of both policies is to impact short-term macroeconomic values, which should be avoided wherever possible. Confidence in the economic system must come from structural soundness, not short-term tinkering. In order to maximize causal coupling, monetary and fiscal policy should only be seen as emergency measures, not solutions—tactics employed to bridge back to sustainable real economic activity.

Implications

It’s time to stop relying only on models of decision making that don’t go far enough in the real world. Causal economics let’s us model any decision consistently in a way that expected utility and behavioral economics don’t. It allows us to apply a simple, powerful and consistent framework to macroeconomic scenarios in order to arrive at solutions that maximize freedom for individuals and ensure appropriate accountability to society. Causal economics provides a fresh and exciting new approach to contemporary issues that provides clarity in these heated political times