Human Nature And The Financial Crisis

Quick quiz: If there are 1,000 people in a village, and 10% of them have contracted a new, awful disease called acute hotchocolitis, how many people in the village are sick?
This is not a trick question; the answer is 100. An easy question for readers of Forbes. But ask the average American, and one in three will get this question wrong.
There are many reasons we are in our current economic crisis. For one, U.S. tax policies encouraged home ownership, even among people who weren’t in a good position, financially, to take on such responsibility. What’s more, credit rating agencies fell asleep at the wheel, lulled into complacency by the other business they hoped to conduct with the very lenders they were rating.
The free market is often good at punishing bad decisions. In a free market, if you cannot afford your mortgage payments, you either have to sell your house, go into foreclosure or file for personal bankruptcy. If you quit your day job to become an actor, the marketplace will decide whether you can afford to continue chasing that dream.
But no account of the economic crisis is complete until we explore the reasons why so many consumers make so many bad decisions.
If a potential homeowner doesn’t understand things like percentages, how can we expect them to understand adjustable rate mortgages? “The mortgage starts at 5% (five what?), could rise to 7% in three years (seven what?), and if you compound (com huh?) the interest over time …”
Unfortunately, when enough people make enough bad decisions, the consequences can be dire–not just for those individuals who make the bad decisions, but for all of us.
Look at how irresponsible borrowing and lending have hurt even those among us who made wiser decisions. Caveat emptor policies–in which the buyer takes on the entire onus of a bad transaction–ignore the possibility that, if enough consumers make enough bad decisions, our economy will spin out of control.

To truly understand how our economy works, we need to understand consumer decision making. Further, we need to understand human nature. In recent years, for example, many new homeowners were overwhelmed by the mathematical details of their mortgages and, therefore, pushed away fears about whether they could afford these mortgages. Instead, they relied on advice from Realtors, the same people who make more money when their clients buy bigger houses.

Of course, mathematical stumblings don’t account for every unwise mortgage purchase. Instead, some consumers understood the terms of their mortgages, recognized that the mortgages were risky and still went ahead and secured the loans.
These people were susceptible to what behavioral scientists like me call unrealistic optimism: They were convinced that their interest rates would not rise; or they were confident that their salaries would rise faster than their mortgage payments; or they were certain that their house would grow in value, allowing them to sell it for a profit if their monthly payments became burdensome.
Good economic policies need to recognize that we aren’t always rational decision makers with unlimited willpower.
Instead, our decisions are influenced by a horde of unconscious forces. People named Paul, for example, are more likely to migrate to St. Paul, Minn., than other people, under the influence of what psychologists call egoistic bias. (I’m not calling that a bad decision, by the way. I grew up in St. Paul.) Or, to take a very different example: When people are told a cracker contains nine grams of “healthy fat,” they say it tastes worse than when the they are told the same cracker contains nine grams of “unhealthy fat.”
For these reasons, markets work best when policies direct consumers away from their own worst instincts.
That’s why we tax cigarettes, discouraging adults from picking up the habit. Such a policy leaves people free to smoke if they desire, while reducing the chance they will smoke in the first place.
Politically speaking, I am a flaming moderate. I am glad to be living in a capitalist society. But I also believe that when we understand the limits of human nature, we will better know whether, and how, to rein in the excesses of free markets. I hope that we not only recover from our current crisis quickly, but also that, in the meantime, we implement the kind of sensible regulations that will reduce the chance of repeating our recent mistakes.
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Salvaging Detroit by Rebranding Bankruptcy

Just a couple months ago, the nation watched as congress decided not to bailout American automakers, unconvinced that the three companies had sound plans for how to use such funds. Eager not to see any of these companies fail on his watch, President Bush came up with enough funds to tide the companies over for a little while.
Now it is up to the Obama administration to figure out how it will help the ailing domestic auto industry. And it will soon face the same two options that congress contemplated in December: bailout or bankruptcy. Bankruptcy, we are told by the car execs, “is not an option,” because of its debilitating stigma: people just won’t buy cars from companies in bankruptcy. Therefore, it’s bailout or nothing.
This dichotomous choice-of bailout or bankruptcy–will likely rear its head again unless Obama considers a third alternative, one that draws upon the strengths of the bankruptcy process while minimizing its potential stigma, an approach that takes advantage of the insights of behavioral economics, a field that is known to influence Obama’s thinking.
We need to psychologically rebrand “bankruptcy” to prevent it from stigmatizing the big three American car companies.
Some may think that when Detroit automakers warn of the hazards of bankruptcy, they are just posturing to extort federal funds. But let’s assume they’re right – that cars are different and present special problems for bankruptcy. It’s certainly plausible: customers might be willing to buy tickets from an airline in bankruptcy because they know their tickets will be honored and that in any event in at most a few months, their flight will be over and they’ll be back home.
They may not be so sanguine about buying a car. An automobile costs thousands of dollars and requires long-term relationships on warranty and service contracts. There may also be psychology at play, whereby the stigma of bankruptcy contaminates the unique emotional relationship many consumers have with their vehicles.
This brings us to framing. Behavioral science has established that people’s perceptions are powerfully influenced by the way issues are framed. Words like “bankruptcy,” and “bailout,” elicit powerful emotions, causing people to make rapid and intuitive judgments. Given the strength of these emotions, people can know that bankruptcy will strengthen an automobile company while still feeling like the company is thereby doomed. They can know that their Chevy is the same car it has always been while feeling like it has been diminished.
So can we give Detroit the benefit of bankruptcy protection without the stigma?
Of course we can. The Obama administration could work with Congress to create specific legislation for Detroit, drawing upon the most helpful and relevant aspects of bankruptcy law while making sure not to characterize the legislation as a “bankruptcy” bill. Call it, say, “Operation Solvency.”
Under this legislation, the automobile companies would use the holdout-binding power of bankruptcy law to compel all stakeholders to take concessions to restructure the balance sheets, as well as give the companies some breathing time to roll out new, more viable business plans, such as brand reduction. (This is something that can’t be done with mere bailout funds, because there’s always the specter of holdout.)
In fact, we’ve done this before. When Congress was worried about the stigma of personal bankruptcy, they styled what is now chapter 13 of the Bankruptcy Code, which they reframed as a “wage earner plan.” It could do the same thing with Detroit.
This is not just bait and switch; this is recognition of the insight of behavioral science that framing matters. If the stigmatizing effects of bankruptcy for automobile consumers is real (even if they are exaggerated in congressional hearings), then we should be mindful of their consequences when billions of taxpaying dollars are at stake – not to mention hundreds of thousands of jobs.
If we’re going to craft legislative intervention, let’s at least frame the matter right. Then, and only then, can Detroit can get to work on making itself relevant again in the global automobile industry.
Note: I co-authored this post with John A. E. Pottow, a Professor of Law at the University of Michigan and co-publisher of www.creditslips.org, the leading academic blog on bankruptcy.
To see my posts from other sites, or to learn about my book Free Market Madness: Why Economics is at Odds with Human Nature-and Why it Matters, go to https://www.peterubel.com/.
View original post and comments at Scientocracy

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