Tuesday, January 31, 2012

Consumer financial protection, 1984

The Financial Times reports an amazing interview with Martin Wheatley, the "head of the UK's new consumer protection watchdog."
Investors cannot be counted on to make rational choices so regulators need to “step into their footprints” and limit or ban the sale of potentially harmful products,

“You have to assume that you don’t have rational consumers. Faced with complex decisions or too much information, they default ... They hide behind credit rating agencies or behind the promises that are given to them by the salesperson,” said Mr Wheatley..

The new approach rests on research in behavioural economics that shows investors often make decisions contrary to their own interests because of their aversion to losses or unwillingness to ditch a losing strategy. It represents a profound shift in regulatory stance.

Rather than simply ensuring that consumers are provided with complete and accurate information, the FCA will be monitoring firms to make sure that the right kinds of products get sold to the right kinds of people.

I can't wait to see the Nanny State plan to help day traders to ditch those losing stocks faster. 

Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook.

Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?

Sure, the market will get it wrong. But behavioral economics, if you take it seriously,  predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions.

More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong. 

Serious behaviorists know this. Thaler and Sunstein's "Nudge" is pretty careful not to jump from "people make mistakes" to "a benevolent bureacracy must take care of the charming moronic pesantry." Alas, fans of 19th century aristocratic paternalism, who call themselves "liberals" today, make the jump with alacrity. They love to (mis-) cite behavioral economics as cover for their interventions. As, apparaently,  Mr. Wheatley and the UK "protection" scheme he will now lead.

If he were to take behavioralism seriously, the interview would reveal a deep reflection on how he was going to keep his new agency from displaying all those biases likely to lead to bad decisions.

For example, his new power to tell bank A that its products are "mis-sold" will quickly and predictably lead to bank B taking his employees out to lunch to explain how terrible bank A's products are and how it must be stopped. "Consumer protection" has quickly morphed into "protection from competitors" the world over, and the behavioral biases of regulators (salience, social networks, etc.) are part of the story. "Watchdogs" become lap-dogs.

Where are the behavioral Stigler and Buchanan? It seems high time for a thoroughgoing behavioral analysis of the functioning of government bureacracy, legislation, and regulation.

Here's some real "financial protection" advice: Look at the elephants in the room.

The first thing the average American should do is get out of a highly leveraged, very illiquid investment that poses huge idiosyncratic risk. That's called an "owner-occupied home." Rent, and put the money in the stock market.  Or buy a smaller home, that you can afford. Our government is still nudging us in exactly the wrong direction

The seond thing the average American should do is save a whole lot more. Our government is pushing more subsidies for student, homeowner, and business loans, and dramatically raising the already high taxes on saving and investment. When the American consumer tried to start saving a bit more in 2008, our Government responded with massive "stimulus" whose explicit purpose was to undo this bout of national thriftiness and get us to consume more, now.

Who's behavioral here?

Update: (response to some comments).

There is a huge difference between the justifications for regulation.  1) Protecting people from fraud. This is enforcing contracts and property rights, which is an obvious function of government. 2) Protecting people from definable and remediable market failures. That's more tenuous, but still a justifiable form of regulation. Though it's dangerous, see the capture exmaples, and often backfires. 3) "Protecting" people because the beuracracy just thinks it knows how to run people's lives better than they do. This used to be called aristocratic paternalism. Now it's defended by a misreading of behavioral economics. That's what the post is about. I hope that helps. I see it's an issue worth revisiting.