In the previous two entries in this series I introduced you to the field of behavioral economics and then described some of the empirical work and insights from this new field. Unfortunately for those in the payments business, behavioral economics is also used to advocate regulations and other government interventions into this industry. In Making Credit Safer, for example, Professors Bar-Gill and Warren argue that “[m]any consumers are uninformed and irrational,” “consumers make systematic mistakes in their choice of credit products and in the use of these products,” regulations should adopt a number of “behaviorally informed” policies designed to address the consequences of consumer ignorance and irrationality.
These and other members of the “behavioral law and economics school” believe that the findings of behavioral economics sometime provide a basis for government interventions in the market to prevent consumers from harming themselves. Some members advocate “soft paternalism” that ‘nudges’ consumers towards what certain scholars deem to be better choices. Such ‘nudges’ often take the form of default rules which map onto the policy preferences of the academic advocate. Other scholars advocate “hard paternalism” that renders disfavored choices impractical or illegal, even between willing and informed consumers and providers. “Hard paternalism” includes recently proposed “sin” or “vice” taxes aimed at reducing the consumption of junk food, soda, and cigarettes.
Behavioral law and economics scholars favoring both “soft” and “hard” forms of paternalism usually take a dim view of consumer borrowing. They believe that consumers systematically over-value current consumption and do not adequately account for the costs of repayment in the future. As Josh Wright and I noted, some members of this school therefore advocate a variety of prohibitions on consumer lending, including banning subprime mortgages; prohibiting credit cards; requiring the unbundling of transacting and financing services offered by credit card companies so that consumers could not use the same card to make a purchase and then finance it; and applying state usury laws to credit cards. Two leading scholars in this area advocate a ban on credit cards :
The simple policy response suggested by our perspective would be to permit charge cards and to permit debt, but to forbid charge cards that are automatically linked to debt accounts — in short, to ban credit cards as they currently exist. The current legal environment with regard to credit cards is perhaps exactly the opposite of that suggested by our perspective. Credit card companies make it easier and easiercfor people to acquire credit cards, with few restrictions, while at the same time bankruptcy laws are becoming more restrictive for the many people who (predictably) end up buying more than they should. As a result, the situation faced by many consumers is not unlike that faced by the hapless child who is presented with a pile of tempting candy yet threatened with severe consequences if she succumbs to temptation.
So why do consumers have so much trouble making sensible borrowing decisions and why are they so easily duped by lenders? The root of the problem according to the behavioral economics field is that many consumers engage in what’s known as “hyperbolic discounting.” Economists assume that when people make choices about the future they discount values exponentially just as we’ve all been taught to do in doing present value calculations since junior high school. According to many of the behavioral economics studies that’s not quite what people do. Instead they put a lot of weight on benefits they are going to get soon. But they do this in a way that they come to regret. If your future self was your guardian angel today she would tell you to think twice about borrowing money for that new coat and she’d probably also tell you to lay off the Doritos. To put this in policy terms, since your guardian angel realizes you aren’t going to listen to her — you lack willpower — she would like to lobby Congress to pass some laws to prevent you from borrowing money she’s going to have to pay off in the future and making her look fat. Your guardian angel, in this view of the world, should be up on Capitol Hill lobbying for the CARD Act and taxes on junk food.
Fortunately for the lending business this nice sounding story is beginning to unravel. An important empirical paper by Tom Brown and Lacey Plache (full disclosure: they are Visa consultants) find that when you look at credit card data the hyperbolic discounting story doesn’t hold up. Several new studies by behavioral economic specialists are also questioning much of the evidence on which the hyperbolic discounting story was based. Mara Airolki, Shane Frederick and Daniel Read, for example, find that most of the studies don’t really test for hyperbolic discounting and ignore the role of risk in decisionmaking. When they do the right test they find little evidence of hyperbolic discounting. The debate isn’t settled yet, of course, but this work does suggest that it might be a tad early to treat consumers like hapless children.
Movements to ban credit are nothing new.There has been an almost constant thread of moral opprobrium to borrowing from various quarters since the early days of our country. During the 19th century as retailers increasingly provided consumer credit various social commentators warned against the practice. One social critic chastised women for the “curious process of reasoning” that led them to buy on installment rather than paying up front. By the turn of the 20th century, social commentators warned against the evils of spending and going into debt through morality tales such as Keeping Up with Lizzie (which inspired the subsequent comic strip Keeping up with the Joneses).
These commentators also argued that some of modern financial innovations were hurting consumers. Irving Bacheller’s “Charge It” observed in 1912, “Credit is the latest ally of the devil. It is the great tempter. It is responsible for half the extravagance of modern life.” He went on to condemn one of the financial innovations of the early 20th century — the personal checkbook — which he insisted would tempt consumers to spend too much money.
*This blog is based partly on work I’ve done with Joshua Wright of George Mason University.
David S. Evans has been a business advisor to many payment companies around the world. He is the author of Paying with Plastic: The Digital Revolution in Buying and Borrowing which is the definitive source on the payments industry. His more recent work is “Innovation and Payments” which describes the how the combination of data-driven marketing, cloud-based computing, and mobile telephony will transform the payments industry. More here.