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« Previous Entry | Main | Next Entry » Thaler Responds to Posner on Consumer Protection
Paul Solman: Earlier this month, I was pleased to learn that one of the most intriguing economists of my career span, the University of Chicago's Richard Thaler, had entered the rotation of the NYT's weekly "Economic Scene" column. His initial public offering, Mortgages Made Simpler, applied his gargantuan expertise in behavioral economics, a field he helped invent, to home mortgage regulation. (You won't find a briefer, or better, introduction to behavioral economics, BTW, than the first few paragraphs of his column. For my foray into the field with him, see our visit to a New York Yankees game in 2003.) As this page had only recently featured a number of our favorite economists commenting on proposed Obama consumer financial protections, I took special notice. A mere 17 days after Thaler's NYT debut, I opened the Wall St. Journal op-ed page and spotted an essay by the gargantuanly prolific Federal Appeals judge Richard Posner, about whom Nobel laureate economist Ronald Coase is quoted as having said, "He writes faster than I can read." Inasmuch as a link to Posner's blog with Nobel laureate Gary Becker has resided on this page's lower right hand pretty much since inception, and I have quoted him here on the Business Desk, I was all eyes, and the headline -- Treating Financial Consumers as Consenting Adults -- only further intrigued me. I'll leave it to the diligent among you, dear readers, to hyperlink away and compare the arguments. But what dumbfounded me, and occasions this post, was the extent to which Posner took personal aim at Thaler and his argument. What, I wondered, was Thaler's personal reaction? More to the point, what was his response to Posner? So I emailed Thaler to see if he had written a rejoinder. When I found that he hadn't, I invited him to do so, promising that I'd publish it. And so, here it is. Richard Thaler: A few years ago two of my dearest friends, Linda Ginzel and experienced the worst nightmare of any parents. They received a call from the day care center that was taking care of their toddler son Danny. During nap time, Danny had died in a freak crib accident. Danny had strangled himself. In the aftermath the nightmare only deepened. Linda and Boaz discovered that the type of crib in which Danny had died had already led to the death of several other toddlers and had been recalled, but an inspection of the day care center the previous week had not noted the presence of the killer crib. Since Danny's death Linda and Boaz have committed themselves to the cause of preventing other such deaths from dangerous products. (If this story scares you about the safety of your children or grandchildren then good--go to the website of their foundation, kidsindanger.org, and make sure the products used by the kids you love are safe. Donate some money while you are at it.) How should we go about preventing deaths such as Danny's? Three factors should be kept in mind. First, most parents have little knowledge about the properties of a crib (or toy) that makes it dangerous. Second, many do not read the instructions before using the crib. Third, cribs tend to be passed on from one family to another, often without the instructions that have long since been tossed. The crib Danny died in had been donated to the day-care center, almost certainly without the assembly instructions. What these three facts tell us is that cribs should be designed to be fail-safe in the sense that they should not be dangerous even if the user has not read the instructions. Which brings me to the proposed Consumer Financial Protection Agency that is the subject of Judge Posner's essay. As Judge Posner says, one of the jobs of the agency would be to prohibit a product that is likely to "cause substantial injury to consumers" that "is not reasonably avoidable by consumers and . . . is not outweighed by countervailing benefits to consumers or to competition." Furthermore, the administration wants oversight of consumer finance to be based on "actual data about how people make financial decisions". Posner is horrified by these principles. But don't they sound exactly right for the design of regulation for cribs? And, are mortgages and credit cards all that different? The proposal that particularly draws Posner's ire is the idea that the Agency would designate a few types of "plain vanilla" mortgages and suggest that unsophisticated shoppers concentrate their search on those. The idea is very similar to the standard leases used in most rental agreements. The landlord can change the terms of the standard lease, but those changes are done in a way that makes them quite salient to prospective tenants, and the tenants are alerted to the fact that these terms are not the usual ones. The plain vanilla mortgages would all have the same terms (like the standard leases) and issuers who want to offer different kinds of mortgages would have to make their modifications clear. Only mortgages judged to be very dangerous would be banned. The administration has not stipulated how many types of plain vanilla mortgages there would be, but the research on which this proposal is based makes it clear that it is reasonable to assume that there would be at least a fixed-rate and some type of adjustable-rate mortgage in the mix. (For my take on this proposal see my recent NYT column, linked above). Nonetheless, Posner writes as if there would be only one plain vanilla mortgage. This is seriously misleading. An analogy would be to say that we would not want the Consumer Product Safety Commission to regulate the production of cribs because they might decide only to allow pink cribs and some people might like blue ones. Of course the agency would not do that; it would only make sure that whatever color crib you bought would not kill your child. Posner does not stop at mischaracterizing the proposal. He launches a second line of attack based on the following logic. 1) Behavioral economists such as Thaler have endorsed this plan. 2) Thaler has been known to make mistakes. 3) Therefore, he should not be in the business of helping consumers avoid mistakes. Of all the evidence readily available that I am not perfect, he concentrates on the fact that I have written about the well-known puzzle in economics that the difference in returns between equities and bonds (the "equity premium") has, in the past, seemed to be too large. With the market now down, presumably he thinks this writing makes me look foolish. I plead guilty to joining the hundreds of other economists (most of whom are not behavioral economists) who have written about this historical puzzle. And, as Posner suggests, for many years I did advocate that young investors should consider putting all their money in stocks, and I followed that advice myself until 2000 when the level of the stock market bubble got so ridiculously high that I switched half of my retirement portfolio into treasury inflation-protected bonds (TIPS). But of course, I am not a perfect forecaster. I, like most people, did not get out of stocks last summer. And, I certainly plead guilty to being imperfect. For a long list of particulars, contact my wife. But, given that I do not claim to be infallible, what does this have to do with whether we should try to help people make better choices? The premise of behavioral economics is that humans are not perfect decision-making machines. We are busy and distracted. We have fields that we know well, but are amateurs in most other domains. If our car breaks down, we go to a trained mechanic. Even the best mechanics will make some mistakes (they are human), but for most of us they still have a better chance of getting our cars to work than doing it ourselves. Even Judge Posner is human, and given the number of books he has written, he must have made a few mistakes in print. But our legal system needs judges, and one of the reasons we have a layered judicial system is so that mistakes by one judge can be corrected by others. Should we abolish our legal system because judges are known to make mistakes? No government agency (or judge) will be error-free. The goal of the Nudge agenda sketched out in my co-authored book of that title was to create decision-making environments in which it is easier for error-prone human decision makers to choose well. The Agency proposed by the administration is a good example of this kind of thinking. Even imperfect experts can help us achieve better outcomes, just as imperfect judges can help us enforce the law fairly. Until we invent the perfect human (or computer decision-making devise), we have no good alternatives. -- Posted July 28, 2009 | Comments (10) | Permalink
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Standard templates exist for sub-prime mortgages. They makes it easier to package the loans into mortgage security. I believe Dr Thaler is proposing that a Government agency (Feds?) should determine the terms in a mortgage : a return to an era of regulations of the mortgage industry : and that will be a good thing.
The functioning of a 'free market' requires the participant to have good information. When it comes to home mortgages, the information comes from the mortgage broker. The broker makes commission from loans. The UGLIER the mortgage, the more they get paid, so they have every incentive to get the borrower onto the most expensive plan. The loan is then packaged up and sold, so the broker simply doesn't care if the borrower cannot pay. A system that rewards reckless behaviour will only lead to disaster.
To borrow the term 'consenting adults' from Judge Posner, what we have here is two consenting parties (borrower and mortgage broker) consending to rip off a third. (buyer of mortgage security). This should not be allowed. The terms of a mortgage must reflect a probable chance that the loan will be repaid. Otherwise the loan should not be made at all in the first place.
I do not understand why free market advocates continue to oppose government action that is designed to solely provide more information to buyers and sellers that will result in more efficient markets. We all know that human behavior is fallible and that free markets are never the most efficient model because of imperfect information. Let the government act as an information clearinghouse and set default standards. These actions will improve the functioning of markets.
Good article. Although I've disagreed with Thaler on a couple of points in the past, I think this article is spot on.
Indeed there is quite a lot of discussion around the blogs about behavioural finance, bubbles and regulation in the last couple of weeks. Some related thoughts and links: http://www.knowingandmaking.com/2009/07/buzz-about-behavioural-finance.html
The most damning critcisim made by Posner is the following:
And according to the bill, the agency can forbid the seller to offer his own product if the offer would cause substantial injury to consumers that is not reasonably avoidable by consumers and . . . is not outweighed by countervailing benefits to consumers or to competition.
Is this true? If so it violates the most compelling principle of libertarian paternalism: that people always have the ability to opt out of the default rules.
[If so it violates the most compelling principle of libertarian paternalism: that people always have the ability to opt out of the default rules.]
But that is a grave mistake: you can always opt out of the default rules by leaving the country and going to another country with rules that better suit you. The USA have border guards to stop people from coming in, not leaving.
It is perfectly legitimate and libertarian for the majority of a nation to form a group purchase scheme; while each of them individually may not have the time to check financial products, they can well decided to pay a subscription fee to an organization that does. Just like a housing association for any task that a majority of members would rather be done by a contractor than themselves.
And just like for housing associations, the USA does not force the minority to join in those group purchases: they can always take personal responsibility and take up citizenship elsewhere (just and they can sell their condo or house and buy one in a more congenial housing association).
But usually libertarians are not libertarians because they like freedom of choice, and the principle of opting out: because individuals in free countries always have the chance of opting out of a citizenship bargain that is not of mutual advantage, and choose another more congenial one.
My impression is that the usual motivator for libertarian-sounding arguments like Posner's is not libertarianism, but social Darwinism: the idea that there are losers and suckers and that it is immoral to give them a break.
The real problem many have wth Thaler's argument is here:
[The goal of the Nudge agenda sketched out in my co-authored book of that title was to create decision-making environments in which it is easier for error-prone human decision makers to choose well.]
This reads to a social Darwinist at a very undesirable goal: because it means that people who are error prone are helped make less mistakes, and this means that suckers get a break, which is both immoral, and in the long term weakens humanity, as the weak and stupid do not get eliminated.
If there is a loser that chooses [a product that is likely to "cause substantial injury to consumers"] then he should suffer the consequences of being a sucker, and not be discouraged from harming himself. Also such products are a winner's way to make money, and for social Darwinists winners have a right to make money from losers by offering them bad deals.
"Consenting adults" may mean that predators have the right to to screw their prey without interference from meddlesome do-gooders, as long as the prey can be fast-talked into getting screwed. "Buyer beware!".
This is very a very American point of view, often expressed as "it is immoral to give suckers a break".
Indeed behavioural economics itself is often used in the opposite way Thaler wats to. When he says:
[The premise of behavioral economics is that humans are not perfect decision-making machines. We are busy and distracted. We have fields that we know well, but are amateurs in most other domains.]
one possible idea is to use behavioural economics to maximize the chances of people making mistakes in order to take advantage of those mistakes to make bigger profits.
Indeed well before Thaler started talking about behavioural economics many "behavioural economists" were making big money advising businesses on how to structure and package their products to maximize the chances that their customers would pay top dollar for [a product that is likely to "cause substantial injury to consumers"].
Because preventing a loser consumer form signing up for a raw deal also means preventing a winner businessman from profiting from selling that raw deal.
And for social Darwinists helping suckers to avoid signing up for raw deal not only slows down the weeding out of losers, it also punishes winners, both of which they regard as against morality and nature.
"I do not understand why free market advocates continue to oppose government action that is designed to solely provide more information to buyers and sellers that will result in more efficient markets."
Because many supposed "free market advocates" in truth actually care more about the ease that their kind of wealthy and powerful people and institutions can continue to get wealthier and more powerful.
If this coincides with free, efficient markets, then great---but if government intervention helps actually efficient markets and hurts their money-making niche, they're against it.
Efficient, competitive, and transparent markets tend to lower profit margins.
For example, I find that the editorial line of The Economist is usually a fairly honest free-market advocate. The editorial line of the Wall Street Journal to me seems to be nothing but a class advocate for the rich and powerful.
I see the distinction between
The WSJ editorial page is fish wrap. It's not that the page is right-leaning, it's that it routinely employs made-up facts or specious reasoning to advance the cause. I'd bet anything that the misleading portions of Posner's piece were either suggested or placed there by the ideologues at WSJ's editorial board.
Economics is enormously complicated because people are complicated. My problem with libertarianism (or any all encompassing ideology) is that it attempts to address every issue with a broad-reaching, simple principle that may sound great on a lecture podium, but just doesn't work in practice. Adhering to an "ism" can be constraining.
Professor Thaler wins this one on the merits; Judge Posner's crass ad hominem attacks were shocking, and counterproductive to his argument.
Just as with derivatives, standard -- and fully-disclosed -- mortgage terms will benefit both consumers and (in the long run) lenders as well.
If markets were ever as rational as the theory implies, Posner wouldn't have his job as a judge. If every entity (person or business) was always rational and could casually evaluate the positives and negatives before choosing an action, nobody would ever pick inappropriately.
However, we live in a flawed world. Perhaps it's not the one Posner WISHES he was a part of, but quite frankly I'm rather tired of old out-of-touch self-important folk trying to shoehorn the facts of reality into a belief structure they created in their own head.
Posner may be smart, but the Chicago school of thought has got to go. There simply isn't room for "he has a point" - no, he NEVER had a point. The rational markets hypothesis is useful perhaps for Econ 101 - as a 30,000-foot model for how people might act.
But they NEVER DO act this way - they're human.. and it's time economics reflected this.
I love Thaler's response. The humor is wonderful, and I only wish that it could have been presented live in the form of Point_Counterpoint as they had in 60 Minutes years ago.
Alas, this is not mass media, is it just a sorry link on the internet.
But, to ad to the discussion, I would note that the plain vanilla proposal for mortgages as a consumer protection device is not so scary-strange as Posner would suggest. In insurance, states require that there be certain minimum features of, for example, a health policy--lest people believe that when they buy "health insurance" they are actually buying health insurance. This arose from a history in which people sold health insurance that covered practically nothing--I mean it, practically nothing. Sort of like "cancer insurance" for the poor scam. Unfortunately, when insurance commissioners started down this path, what has also happened is that interest groups--dematolgists, chiropractors, etc.--have lobbied to have their "diseases" and threatments added to the insurance template. The same could happen here, which is why it may require vigilance. I would suggest that the legislation include some behavioural and financial modeling to determine what is the plain vanilla sufficient to creat a market and what types of add ons and disclosures--and in what format--all the extras will be so that the changes will be salient to the customer.