Isn't behavioral economics a depressing view of human nature?
It is true that from a behavioral economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman. So from this perspective it is rather depressing. But at the same time there is also a silver lining. There are free lunches!
Take the physical world for example. We build products that work with our physical limitations. Chairs, shoes, and cars are all designed to complement and enhance our physical capabilities. If we take some of the same lessons we’ve learned from working with our physical limitations and apply them to things that are affected by our cognitive limitations-insurance policies, retirement plans, and healthcare-we’ll be able to design more effective policies and tools, that are more useful in the world. This is the promise of behavioral economics – once we understand where we are weak or wrong we can try to fix it and build a better world.
Take again the sub-prime mortgage crisis. Imagine that we understood how difficult it is for people to calculate the correct amount of mortgage that they should take, and instead of creating a calculator that told us the maximum that we can borrow, it helped us figure out what we should be borrowing. I suspect that if we had this type of calculator (and if people used it) much of the sub-prime mortgage catastrophe could have been avoided. This of course is one idea to fix one problem, and there are many ways to think about how to improve our lives along many of the decisions we make every day. This is why I think that behavioral economics is so optimistic, useful, and important for our personal life and for society.
My latest book, The Upside of Irrationality, explores some positive and some negative ways that irrationality plays out in our lives.
In my own field of Human Factors we do the same thing. We design products and systems to maximize performance in light of the physical and cognitive limitations of users.
I think this is also why the idea behind the book “Nudge” is useful.
Dan,
I think one point that is lost here is that the most important factor that turned the housing market into a crisis is not the large number of foreclosures in and of itself. Sure, a lot of people losing their homes is terrible but that alone could not cause behemoths like AIG and Bear Stearns to fail. Around 2000, Congress passed legislation making Credit Default Swaps unregulated. Of course the simile here is that it is as if people started betting on other people’s poker hands, except instead of poker it was mortgage failures. Thus, the effective loss derived from each foreclosure was magnified many times over as far as their lender was concerned. In my opinion, this was the inevitable consequence of these unregulated bets. Perhaps it is Congress that needs a different sort of calculator…
Calculators like this probably exist – http://mtgprofessor.com/ is a good site. What about incentives though? If you look at the players in the transaction, their motives are basically–
Buyers agent: get sales commission with the least amount of work. Higher price = more commission.
Sellers agent: ditto
Mortgage broker: Make the most money on the transaction… whatever mortgage is giving the best incentives. Typically, the higher the interest rate the more money to give the broker.
Buyer’s attorney – look out for their client’s interests.
Unsophisticated buyers, happy to be getting a home at all, don’t understand this. And nobody will explain the conflicts of interest – least of all RE agents, who would be glad to have dual agency.
Dan,
When I was growing up, I was taught rules of thumb that had a lot of threes in them:
* Put 30% down.
* Don’t pay more than 30% of your take-home pay for housing.
* Don’t pay more than three years’ income for a house.
I believe these rules were common wisdom before 1980. Following any two out of three ought to be enough to keep most people out of trouble, even in bad times.
Greed, stupidity, irrationality, short-term thinking. Those are all limitations. Calculators, tables and computer software won’t solve the fundemental problem, which is not shortage in data (even though some of it was only available in very small fonts).
But hey – this is why governments are for. Laws and regulations should also protect us from those pitfalls.
Great comments all, on another provocative post by Dan.
I agree with Eitan and would add ‘fear’ to the list of limitations. All participants noted by Jeff Winkler are plagued by it – add the participants’ families, friends and acquaintences whose biases also influence the decisions and actions of the transactors.
There is hope, but little evidence to support successful “engineering-out” erroneous long-term judgment when super-cycles are by definition the length of a human lifetime, and super-cycles span three centuries.
As some wag asked and answered, “What do we learn from studying history? That we haven’t learned from studying history.”
Behavioral Economics, as many write about it, is depressing. But it doesn’t have to be. The brain is the sophisticated information processor on the planet. The trick is presenting it information in the right way. Behavioral Economics can lead to the design of tools that help people think about important problems in brain-friendly ways. This paper takes a step in that direction:
http://bit.ly/3DByps
The next frontier for behavioral economics must be the fallability of group thinking. The mortgage mess was not really the result of individual flawed decision making. The individual players were all acting rationally within the context of the information they had and the belief system of the larger society. I don’t think the bubble would been avoided by calculators. The fundamental error was the meme that housing prices always rise. Had this concept not been extant, it would not have seemed logical and justifiable for individuals or institutions to have acted as they did. The math just wouldn’t have worked. Understanding how misconceptions such as this become universally accepted by a large group is a critical task for behavioral economics. It is easy to identify many false societal memes that have led us astray. One that particularly troubles me and could lead to even more catastrophic consequences than the mortgage meltdown is the belief that mutually assured destruction will prevent nuclear war.
I see this as an information problem. All of the sensible rules above in some way limit the amount of money that bankers and Wall Street can make on mortgages. So they have a clear interest in downplaying and limiting the propagation of such rules. And they can put a lot of money behind any set of alternate “rules” which allow them to make more money.
This applies to mortgage brokers who perpetrated, allowed, or committed fraud on loan applications. As long as there was no default in the first six months, they got their money. So, nearly anything goes.
This also applies to banking lobbyists, who get congress and regulators to allow more CDS, Glass Steagall, etc.
The problem is that while consumers and taxpayers have a clear interest in more regulations and rules, that interest is diffuse, and there are no profits at stake, that can be used to advance a message.
Another way of looking at this is that the big money already knows about the irrationality that Dan writes of, and use it to make more money for themselves.
We should show everyone how much they will eventually pay for the loan product. Take car loans, house loans, any kind of loan. Show them the Total cost through the life of the loan. There are now 6 yr car loans. Unbelievable. If people saw how much they were really paying for that car over the life of the loan they would get a less expensive car, put more money down, or get a shorter term. Same thing with 30 year loans for houses. I remember when 3 and 4 yr was the maximum term for car loans and 20 yrs for house loans.
Show the total cost paid for the life of the loan. And also demonstrate the effect of any penalties, fees, and charges incurred if payments are late or a negative life experience causes payments to be missed.
Currently, we always show best case scenario’s and never prepare the investor for the worse case.