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Thursday, April 17, 2008

Applied Behavioral Economics

A call for "simplified transparency":

Economic policy for humans, by Richard H. Thaler and Cass R. Sunstein, Commentary, Boston Globe: ...If the next president appointed a behavioral economist as the chairman of the Council of Economic Advisors, what sort of advice should we expect to hear? Let's consider the mortgage crisis as an example.

In a standard economic analysis..., the working hypothesis is that borrowers are capable of choosing the best mortgage for their financial circumstances.

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

In today's markets with variable rates, prepayment penalties, balloons, and so forth, even economists have trouble sorting out which mortgage is best. It doesn't help that the market has some pushy mortgage brokers who get paid based on the profitability of the loan.

Many borrowers who are now in trouble made poor choices... Other borrowers were just speculators... Policies aimed at helping those in trouble now should be targeted at the first group, not the second.

From the standpoint of behavioral economics, two kinds of policies make good bipartisan sense. First, some aid should be offered to the homeowners who were bamboozled into taking bad loans. Congress is considering several such proposals...

Critics of such a plan call it a "bail-out." But if the program is limited to owner-occupied homes, the adverse effects will be limited. Stabilizing the real estate market is a legitimate government goal.

Far more important, it 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."

The Truth in Lending Act, enacted in 1968, was a good start... That law required lenders to report interest rates in terms of Annual Percentage Rate, so that borrowers could easily compare ... different loans.

The problem now is that both mortgages and credit cards have rates that vary over time, and numerous other fees that are difficult to understand. It has now become virtually impossible to offer a simple, one-page, plain-English document that explains all the relevant features...

The best response would make use of modern technology to create a Truth in Lending Act for the 21st century. In brief, government would achieve simplified transparency by requiring all lenders to provide borrowers with an electronic file that contains, in standardized form, information on every feature of the contract. ... And because disclosure would be standardized, consumers could easily compare...

Now, you might wonder, how do these electronic files, even if standardized, help us mortals who have trouble learning how to record a TV show...? The answer would come through the market.

As soon as the government required electronic disclosures, websites would quickly emerge to help people in the task of comparing offerings. A borrower would go to "mortgageevaluator.com," upload the relevant quote, and receive an easy-to-understand analysis...

This proposal illustrates the essence of good policymaking from the standpoint of behavioral economics. Government does not tell people what to do. Instead, it tries to improve markets by making it easier for busy people to make good decisions.

Whether we use behavioral economics to justify forcing disclosure of easy to understand, useful information to market participants, or use the justification that markets function best when participants are well-informed, i.e. the more old-fashioned reasoning that forcing disclosure of information overcomes a market failure, the current foreclosure problem shows that more transparency would be helpful. But we shouldn't stop there, there other problems to worry about in these markets besides lack of transparency, and no single policy will be enough to resolve all of them.

In addition, I wonder if people would be sufficiently informed even with a system like this in place. Maybe it will get easier as all of this goes online, but it still seems a bit cumbersome to do the actual comparisons, and even with nice clear charts, explanations, etc., there's a lot of information to absorb to compare loans of various types given all the possible variations in loan terms. If it's generally overwhelming no matter how patiently and well it's explained, should the types of risks people are allowed to be offered be regulated in some way to prevent people from being coerced into accepting high risk contracts? Perhaps realigning incentives in these markets so that mortgage brokers have a greater share in the consequences of loan foreclosures would accomplish this goal without having to specify the types of loans that could be offered. In any case, we should use whatever behavioral economics has to offer, but that shouldn't be all that we do.

    Posted by on Thursday, April 17, 2008 at 12:47 AM in Economics, Financial System, Market Failure | Permalink  TrackBack (0)  Comments (33)

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