Thaler Responds to Posner on Consumer Protection

BY busadmin  July 28, 2009 at 10:27 AM EDT

Richard Thaler and Richard Posner

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,, 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.