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.
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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