Behavioral Economics Then and Now

“Although it has never been clear whether the consumer needs to be protected from his own folly or from the rapaciousness of those who feed on him, consumer protection is a topic of intense current interest in the courts, in the legislatures, and in the law schools." So write James J. White and Frank W. Munger Jr. in a 1971 article from the Michigan Law Review.

Today, it is not uncommon for behavioral economists to weigh in on financial regulatory policy and consumer protection. White and Munger, not economists but lawyers, played the role of behavioral economists before the phrase was even coined. They managed to anticipate many of the hypotheses and themes that would later dominate behavioral economics-- but with more informal and colorful language. A number of new legislative and judicial acts in the late 1960s provided the impetus for their study: 

"Congress has passed the Truth-in-Lending Act; the National Conference of Commissioners on Uniform State Laws has proposed the Uniform Consumer Credit Code; and many states have enacted retail installment sales acts to update and supplement their long-standing usury laws. These legislative and judicial acts have always relied, at best, on anecdotal knowledge of consumer behavior. In this Article we offer the results of an empirical study of a small slice of consumer behavior in the use of installment credit. 

In their recent efforts, the legislatures, by imposing new interest rate disclosure requirements on installment lenders,  have sought to protect the consumer against pressures to borrow money at a higher rate of interest than he can afford or need pay. The hope, if not the expectation, of the drafters of such disclosure legislation is that the consumer who is made aware of interest rates will seek the lowest-priced lender or will decide not to borrow. This migration of the consumers to the lowest-priced lender will, so the argument goes, require the higher-priced lender to reduce his rate in order to retain his business. These hopes and expectations are founded on the proposition that the consumer is largely ignorant of the interest rate that he pays; this ignorance presumably keeps him from going to a lender with cheaper rates. Knowledge of interest rates, it is believed, will rectify this defect…”

Here comes their "squatting baboon" metaphor:

“Presumably, consumers in a perfect market will behave like water in a pond, which gravitates to the lowest point-i.e., consumer borrowers should all tum to the lender that gives the cheapest loan. We began this project with a strong suspicion-based on the observations of others-that the consumer credit market is far from perfect and that water governed by the force of gravity is a poor metaphor with which to describe the behavior of consumer debtors. The consumer debtor's choice of creditor clearly involves consideration of many factors besides interest rate. Therefore, a metaphor that better describes our suspicions about the borrower's behavior in a market in which rate differences appear involves a group of monkeys in a cage with a new baboon of unknown temperament. The baboon squats in one comer of the cage near some choice, ripe bananas. In the far comer of the cage is a supply of wilted greens and spoiled bananas, the monkeys' usual fare. Some of the monkeys continue eating their usual fare because they are unaware of the new bananas and the visitor. Other monkeys observe the new bananas but do not approach them. Still others, more daring or intelligent than the rest, seek ways of snatching an occasional banana from the baboon's stock. The baboon strikes at all the brown monkeys but he permits black monkeys to eat without interference. Yet many of the black monkeys make no attempt to eat. One suspects that a social scientist who interviewed the members of the monkey tribe about their experience would find that many of those who saw and appreciated the choice bananas would be unable to articulate the reasons for their failure to eat any of them. The social scientist might also discover that a few who looked at the baboon in obvious fright would nevertheless deny that they were afraid. In addition, he might find that some were so busy picking fleas or nursing that they did not observe the choice bananas at all. We suspected that consumer borrowers had similarly diverse reasons for their behavior.

We presumed that some paid high interest rates only because of ignorance of lower rates and that others correctly concluded that they could not qualify for a cheaper loan than they received. Others, we suspected, were merely too lazy or too fearful of bankers to seek lower rates.”

Suggesting that people are just lazy, or comparing them to monkeys, has (understandably) fallen out of fashion. But pointing out that consumers are not Homo economicus has not. The authors interview people in Washtenaw County, Michigan who had purchased a new car in 1967. Most of the lenders in the area loaned money at the legal maximum add-on, while Huron Valley National Bank (HVNB) loaned at a significantly lower rate. They interview an HVNB loan officer to determine whether different borrowers would have received a loan from HVNB in 1967 and at what terms. They find that most of the consumers in their sample could have borrowed at a lower rate.

A majority of the sample did not know the rate at which they had borrowed. Most had allowed the auto dealer to arrange the loan rather than shopping for the lowest rate. Even if they knew that lower rates were available elsewhere, they declined to shop around. The authors find differences in financial sophistication, education, and job characteristics between consumers who shopped around for lower rates and those who did not. They conclude:

“The results of our study suggest that, at least with regard to auto loans, the disclosure provisions of the Truth-in-Lending Act will be largely ineffective in changing consumer behavior patterns. Certainly the Act will not improve the status of those who already know that lower rates are available elsewhere. And we discovered no evidence that knowledge of the interest rate-which, even under the Act will usually come after a tentative agreement to purchase a specified car has been reached-will stimulate a substantial percentage of consumers to shop for a lower rate elsewhere.”

The authors come down as pessimistic about the Truth-in-Lending Act, but make no new policy recommendations of their own. If they were writing today, instead of just predicting that a policy would be ineffective, they might suggest ways to design the policy to "nudge" consumers to make different decisions. The Truth-in-Lending Act has been amended numerous times over the years, and was placed under the authority of the Consumer Financial Protection Bureau (CFPB) by the Dodd-Frank Act. Behavioral economics has played a central role in the work of the CFPB. But the active application of behavioral law and economics to regulatory policy is not universally accepted. For example, Todd Zwicki writes:

"We argue that even if the findings of behavioral economics are sound and robust, and the recommendations of behavioral law and economics are coherent (two heroic assumptions, especially the latter), there still remain vexing problems of actually implementing behavioral economics in a real-world political context. In particular, the realities of the political and regulatory process suggests that the trip from the laboratory to the real-world crafting of regulations that will improve consumers’ lives is a long and rocky one."

Zwicki expands this argument in a paper coauthored with Adam Christopher Smith. While I'm not convinced that their rather negative portrayal of the CFPB is warranted, I do think the paper presents some provocative cautions about how behavioral economics is applied to policy--especially the warning against "selective modeling of behavioral bias," which I have heard even top behavioral economists caution against.