Bryan Caplan  

Economic Policy for Humans? What Thaler and Sunstein Miss

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Thaler and Sunstein's latest piece provides a perfect illustration of what's wrong with "sophisticated" critiques of laissez-faire. They begin sensibly enough:

In the past 20 years, there has been a growing interest in cutting-edge research that has come to be called "behavioral economics." In behavioral economics, the robot-like creatures who populate standard economic theories are replaced with real human beings.
So far, so good; who wouldn't prefer theories with real human beings to models with "robot-like creatures"? Thaler and Sunstein then provide a vivid example:
In a standard economic analysis of the mortgage market, the working hypothesis is that borrowers are capable of choosing the best mortgage for their financial circumstances.

This assumption might have been reasonable back in the days when nearly every mortgage was a simple 30-year fixed-rate loan. It is now preposterous.

I'm still on board. After all, I've got a Ph.D. in econ, and I opted for a simple 30-year fixed-rate loan precisely because I thought that other offers were too hard to evaluate.

But with their next passage, Thaler and Sunstein lose me:

[I]t is crucial to design policies that will prevent similar problems in the future. Behavioral economics provides specific suggestions not just for mortgages but also for credit cards, cellphone plans, prescription drugs, and student loans. The basic idea is that for complex financial products, the government should strive for what might be called "simplified transparency."
Here's the thing: I've been through the whole mortgage process, and seen what government actually does. We don't have laissez-faire now. Instead, we have a grotesque web of regulations and lawsuit avoidance that already make the mortgage process ridiculously complicated. I had to hear a dozen mandatory mini-lectures and sign or initial at least twenty pages because the government wanted to "protect" me. And if I didn't understand half the stuff I was signing, how many "real human beings" did?

In short, government long ago took up the burden of helping consumers, and the result is a mess.

The problem with behavioral economics is that it's more sophisticated than standard econ, but not nearly sophisticated enough. Thaler and Sunstein may have a more realistic view of borrowers than the average economist, but they have an even less realistic view of the political process. As I argue in The Myth of the Rational Voter:

Before we emphasize the benefits of government intervention, let us distinguish intervention designed by a well-intentioned economist from intervention that appeals to noneconomists, and reflect that the latter predominate. You do not have to be dogmatic to take a staunchly promarket position. You just have to notice that the "sophisticated" emphasis on the benefits of intervention mistakes theoretical possibility for empirical likelihood.
Additional regulation of mortages isn't going to help real human beings cope with complexity. Democracy already gave us a pile of inane "pro-consumer" regulation, and reform will probably just give us more of the same.

So what would I recommend? Abandon the vain effort to protect consumers from themselves, and switch to a message simple enough for real humans to understand:

1. You're an adult; if you screw up it's your problem.

2. If you're baffled by the complexities of mortgage markets (or anything else), stick with the simple, standard options that you actually understand.


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TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/818
The author at Newmark's Door in a related article titled Disclosure writes:
    Bryan Caplan superbly replies to those who think more government-mandated disclosure would help us avoid another sub-prime problem (or pretty much any other problem):Here's the thing: I've been through the whole mortgage process, and seen what governme... [Tracked on April 24, 2008 4:56 AM]
COMMENTS (16 to date)
liberty writes:

Well said.

I agree with everything, except I think the emphasis on the problem of government intervention should not be on the reality of the intervention that gets passed differing from what "well intentioned economists" would like to see pass.

"Well intentioned economists" have been the cause of most of the destructive interventions of the past century, not because politicians strayed from what the economists suggested, but often because they followed it to the letter.

Dan Weber writes:

Sunstein has been guest-blogging at Volokh this week, FWIW.

GU writes:

Right on Bryan! Let people know that if they swim with the sharks, they may get bit, and the government won't be there with a life raft to save them from their poor choice!

David Robinson writes:

"'Well intentioned economists' have been the cause of most of the destructive interventions of the past century, not because politicians strayed from what the economists suggested, but often because they followed it to the letter."

Not necessarily. Even Keynes's prescriptions weren't NEARLY as destructive as what FDR actually did- they were twisted from reasonable theories about price levels into an excuse for all kinds of populism. Smoot-Hawley, price controls, and lots of other New Deal policies were decidedly ANTI-Keynesian.

Alex writes:

There is no way the government can regulate away all risk or force borrowers to understand complex financial instrments. To the extent people don't have a solid understanding of mortgage financing (most don't), they can and should hire someone who does. ...Or stick with a 30-year fixed.

FC writes:
[...]for complex financial products, the government should strive for what might be called "simplified transparency."

I remember Al Gore "reinventing government." Leviathan, heal thyself.

Matt writes:

"After all, I've got a Ph.D. in econ, and I opted for a simple 30-year fixed-rate loan precisely because I thought that other offers were too hard to evaluate."

Let us look at Arnold's decision from the viewpoint of an evolutionary biologist. What Arnold, and the rest of us, struggle with in mortgage loans is our inability rank by ordinality various loan packages, too many, and the ranking process takes time.

But, long ago, evolution create something nice, cardinal thinking. It allows Arnold to estimate the herd, in aggregation, and his estimate is the 30 yr loan.

Long ago, evolution randomly flipped a gene that allows organisms to estimate the herd by olfaction, very, very early in mammalian development; maybe the first step, maybe the founders gene. So the individual squirrel in the orchard will arrange himself ordinally within the group, but when that gets beyond his ability, he finds herd center by smell.

How evolution did this, and how we can measure our "Ordinality" is crucial to behavior studies, market stability, the development of physics instruments, almost everything, really.

If the evolutionary biologist can prove that our ordinality is a fixed value, say 10, then right away economists should know the inflection point, of a herd distribution, a market distribution, or even predict the design of the next generation of particle physics instruments. Economists would also know, therefore, the market quorum needed to achieve cardinality.

KipEsquire writes:

Austrian-friendly NYU economist Mario Rizzo has just postedon SSRN a draft paper with a detailed debunking of Nudged:

The "new paternalism" claims that careful policy interventions can help
people make better decisions in terms of their own welfare, with only mild or nonexistent
infringement of personal autonomy and choice. This claim to moderation is not
sustainable. Applying the insights of the modern literature on slippery slopes to new
paternalist policies suggests that such policies are particularly vulnerable to expansion.
This is true even if policymakers are fully rational. More importantly, the slippery-slope
potential is especially great if policymakers are not fully rational, but instead share the
behavioral and cognitive biases attributed to the people their policies are supposed to
help. Accepting the new paternalist approach creates a risk of accepting, in the long run,
greater restrictions on individual autonomy than have been heretofore acknowledged.

Publius writes:

The Rizzo stuff is interesting, but I feel Bryan's counterargument runs shallow.

The fact that pro-consumer has failed in the past doesn't mean it's not worth trying to identify pro-consumer reform that would work anymore than we should be put off by the fact that free-market reform has failed many times (most grotesquely in many South American countries).

The world's changed a lot over the years, and certainly innovations in governance seemingly impossible in the past have come true. I don't think we should throw the baby out with the bath water, especially given your agreement that the "masses" need to be set up to make good decisions.

dearieme writes:

Government interference in Britain has reached the point that if you want to open a new savings account and invest, say, one pound, the bank feels it must interview you for 20 minutes. But if you want to go and gamble thousands of pounds a week, go right ahead. Including on the government's lottery. Bah humbug.

Patrick writes:

If you ever read the terms of service for any web based software (GMail, SalesForce, NetSuite, etc.) you notice some funny lines. All the terms say that they can lose your data, arbitrarily shut down the service, or allow your site to get hacked, and you have absolutely no recourse. You even sign away your right to sue.

Yet, data loss is extremely rare. Why? Because for these companies reputation is everything. One episode of massive data loss could destroy a billion dollar software company. If our economy required people to actually read and understand every contract they signed, nobody would ever buy anything or sign any contracts. Our economy runs on trust and reputation.

The real question is, what happened in the mortgage lending market that all the companies suddenly found it profitable to try and screw their customers?

Sinclair Davidson writes:

That is good advice. What is interesting is the perspective on 30-year fixed rate loans. In the US, I understand, they are the norm. Anything else is 'exotic'. In Australia (where I live) many (even most?) mortgages are variable rate and that is now the norm. The existance of 'exotic' mortgages per se is not a problem, neither is securitisation.

Nathan Smith writes:

The problem with the "You're an adult; if you screw up it's your problem" line is that if you screw up, it's the government's problem too, because they have to enforce the contracts that you stupidly signed. Worse, they have to interpret them, which can lead to court cases. That's probably a minor objection in this particular case, but it's a stand-in for what you might call an anarcho-capitalist critique of libertarianism that may be important. In short, when and why should the taxpayers foot the bill for the cops who ultimately back up the bank's ability to repossess the improvident borrower's house?

bee writes:

Great points Bryan!

I believe that behavioral economics suffers from a number of material maladies that limits it value to economics as foundational. The major weaknesses are the following ...

(1) Its assumptions at the individual level are no more robust than those of traditional economics. Most of the work they have done to date demonstrates and weakly categorizes deviations from "classical" economics.

For example, we have anchor and adjust, framing, and recency effects and prospect theory which offer a means of categorizing biases. These explanations are fine but they do not constitute anything more than a descriptor to decisions. That is, they are not cognitive processes.

Further these effects while robust, have a number of issues. One issue is that they are main effects. Much of the research does not show under what conditions they are overcome. Even in the best of these tests we see people making "rational" decisions. They are disregarded because they are smaller than the test cell. While statically valid, it leaves open the question as to why some material group acted "rationally." Further, we do not mechanism or the conditions the rational behavior would be observed.

(2) A second criticism of behavioral economics is that many of the theories offered suffered from the same maladies classical models do. Prospect theory equation fitting in experimental setting is just as complex as it in classical work. The models need to constantly tweaked and are brittle. Thus they are in reality no different on this dimension. I would argue that this arises because BE is merely a tweak and fails to accept that it is explaining cognitive processes.

(3) A third weakness is that it does not explain aggregate behavior as well as classical models. This is important for two reasons. One, the real goal of economics is not to explain individual behavior but to explain exchanges and markets. Thus, missing the explanation level for individual level predictability is unacceptable. Second, group or aggregate dynamics are not explicitly accounted for BE. BE by the way is not good cognitive science.

LemmusLemmus writes:

To summarize your view:

1. Because I, a smart econ Ph.D., was able to figure out how to reduce my choice set, everybody should.

2. Because I can point to government regulations that are bad, it follows that all conceivable government intervention, even if it does not restrict choice, is bad.

I'll leave it to other people to figure out what's wrong with these views.

dee writes:

According to research at the FTC attempting to create better mortgage disclosure forms, 51% of people polled using current disclosure forms could not even identify the amount of the loan.

http://www.ftc.gov/os/2007/06/P025505MortgageDisclosureexecutivesummary.pdf

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