Shiller: A Stimulus for Financial Advice?

Robert Shiller says we need to provide subsidized financial advice:

How About a Stimulus for Financial Advice?, by Robert Shiller, Economic view, NY Times: In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. ... But a much more ambitious effort is needed.

The government programs that are already under way are akin to distributing computer manuals. But when something goes wrong with a computer, most people need ... an expert to guide them through the repair process... The same is certainly true for issues of personal finance.

The significance of this was clear at the annual meeting of the American Economic Association this month in San Francisco, where several new research papers showed the seriousness of consumer financial errors and the exploitation of them by sophisticated financial service providers. ...

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism ... sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Such advice is tax deductible, so it is already subsidized indirectly. But most lower-income people do not itemize deductions on their tax returns, so they don’t receive this benefit. In addition, their income tax rates are lower, so the deduction’s benefits can be even less — sometimes zero if they pay no taxes. That’s why it makes sense to subsidize the advice enough that lower-income people will really buy it... In this case, it means reimbursing qualified private financial advisers for most or, sometimes, all their fees.

Subsidized financial advisers should be licensed by self-regulatory organizations that verify their qualifications. Licensing will be imperfect, and some incompetent advisers will end up with subsidies. Still, the net effect of getting professional advice to the public is surely positive.

To qualify for a subsidy, the advisers would have to sign a statement promising loyalty to their clients and agreeing to accept only the subsidized hourly fee, and never any commissions or kickbacks. The subsidies might come to $75 an hour, at a very rough estimate, and if 50 million Americans averaged four hours of consultations, the eventual cost might be $15 billion a year — a substantial expenditure, but a worthwhile one.

If personal financial advisers had been subsidized years ago with the best incentives, they still might not have stopped their clients’ bubble thinking during the boom. Many advisers probably thought that housing investments were a good bet. But it’s still likely that advisers ... would have been a helpful influence, suggesting caution to those who were getting over their heads... For these reasons, financial advisers probably would have reduced the severity of the housing bubble.

Professional financial advice is now generally accessible only by the relatively wealthy. Changing this would be an important corrective step. Giving the general public access to trained advisers would be a boon for the nation in this time of doubt and distrust.

Are there market failures or other imperfections that government intervention can overcome? I think the informational asymmetries in these markets are large and exploitable, and I also think there are externalities in these markets, i.e. costs that are incurred collectively that are not part of the individual's decision process (other market failures?).

So I do think there is room for correction of these markets through government intervention, particularly the informational asymmetries - the typical household is no match for experienced players in these markets. The question, then, is whether this is the most effective way to overcome the market imperfection. I am not sure that it is, but I can't say I have any demonstrably better ideas. One alternative is to restrict the kind of activities that people in these markets can engage in, but I think that heavy handed, restrictive intervention should only come if less restrictive approaches such as education through pamphlets, advisors, etc. will not solve the problem. Elimination of the informational asymmetry directly by providing the information to households in easy to understand summary form or through trusted advisors is preferable since it corrects the market imperfections rather than putting up blockades to prevent the imperfections from expressing themselves. But, as the ratings agencies for financial products that are supposed to play the role of providing easy to understand, quality information have shown us, that doesn't always work.