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.


  1. A behavioral analysis of government bureacracy would be truly mind numbing. Thanks for this post.

  2. I think you are over looking the problems that led to the housing bubble bursting.

    predatory and loose lending practices.

    Ask someone if they know how much they can afford to spend on a house. More often than not, they will not know because purchasing a home is very complicated.

    Who do you go to for advice on how much you can afford to spend on a home? A mortgage officer, who generally works for a bank or some type of loan agency.

    The point is, we are suppose to be able to trust the professionals, but the companies they work for sometimes misguide them into promoting unethical business practices.

    But I do agree that there could be some more research into how government can play a better role in regulating the kind of products that are being sold.

    1. The housing bubble was caused by the government bribing and coercing lenders into making bad loans to poor people. How is that a problem with markets?

  3. I don't see how the federal government would ever reconcile the objectives of housing the poor through the market while keeping investments "safe".

    I only see two directions they are likely to go down this path: eliminate the marketplace entirely, or simply start building homes/apartments to give away.

  4. Describing it as "behavioural" is unfortunate but investors do need more more protection. If billions of dollars in supposedly segregated accounts at MF Global can just disappear into thin air then there is something seriously wrong with the whole regulatory framework of the investment industry.

    People should do serious jail time (as in life in prison in someplace really nasty) for the situation at MF Global and the United States should bring in some real oversight on the investment industry so that, you know, if a client asks "where did my money go?", there is a locked down audit trail that shows exactly where it went.

    The regulatory scheme for the investment industry has to assume that 10% of the people working in the industry are latent or overt criminals looking for an opportunity to steal and a majority of the rest don't understand the investments they are dealing in. If a majority of investment bankers were both honest and competent the financial crisis would never have happened.

  5. It seems to me that bankers accurately assessed the level risk they were exposing themselves to: none. They got bailed out and they knew they would be if the market crashed, so why not bet the farm by leveraging themselves all to hell and throw the dice as much as they want?

  6. Could you please provide some support for the claim 'But behavioral economics, if you take it seriously, predicts that the regulator (the regulatory committee) will get it far worse.'?

    All individuals are susceptible to behavioural biases, including regulators, but such biases are more relevant in some domains than others. I'm sure regulators have present biases with respect to own consumption, mis-calculate risks, in their own consumption and investment decisions, but the same biases may not be relevant in assessing the behaviour and biases of others.

    You seem to be concerned that lobbyists will influence regulators and this will be the source of biases of regulators, but if the rules under which the regulator works are well-defined this need not be a problem. I.e. in your example the regulator is only permitted to lunch with Bank A when Bank B is present too.

  7. I agree with El Maratonero - research in behavioural economics specifically predicts that our decision making as related to judging our own actions is biased, but that it is far less biased in judging actions of others

  8. See Adam Smith's "Lectures on Justice, Police, Revenue and Arms," re-titled "Jurisprudence" at the online library of liberty website. Note the 'planning' aspect of regulation, and of course, in the second clip, what the people _you_ apparently wish to "protect" are really after. Really !

    Mr. D’Argenson, he told him that the king required three things of him who held that office [Prime Minister] that he should take care of 1st, the cleanness or saneteté; 2d, the aisance, ease or security; and 3dly, bon marché or cheapness of provisions.—The 1st of these is too mean and trifling a subject to be treated of in a system of jurisprudence.
    The 2d is of two sorts, first that which provides for the security of the inhabitants against fires, or other such accidents. This also is of too trifling a nature to be reckoned a branch of jurisprudence. The other branch is that which provides against any injuries that may be done by other persons to the inhabitants; and this end is accomplished either by guards and patroles that prevent the commission of such crimes as it were a priori, or by the constitution of statutes for the punishment of transgressors and the encouragement of those who discover the offenders and bring them to justice.—The 2d part may be called the justice of police, and as it is connected in that manner with the former part of jurisprudence, we shall consider it under that head.
    The 3d part of police is bon marché or the cheapness of provisions, and the having the market well supplied with all sorts of commodities. This must include not only the promoting a free communication betwixt the town and the country, the internall commerce as we may call it, but also on the plenty or opulence of the neighbouring country. This is the most important branch of police and is what we shall consider when we come to treat of police; and in handling it we shall consider the different regulations that have subsisted in different countries and how far they have answered the intentions of the governments that constituted them; and this we shall [trace] to ancient as well as modern times.
    …the creatures of the civil law …monopolies and all priviledges of corporations, which tho’ they might once be conducive to the interest of the country are now prejudicial to it. The riches of a country consist in the plenty and cheapness of provisions, but their effect is to make every thing dear. When a number of butchers have the sole priviledge of selling meat, they may agree to make the price what they please, and we must buy from them whether it be good or bad. Even this priviledge is not of advantage to the butchers themselves, because the other trades are also formed into corporations, and if they sell beef dear they must buy bread dear. But the great loss is to the public, to whom all things are rendered less comestible, and all sorts of work worse done.

  9. Can we delicense lawyers? What is the need for every state to license lawyers?

    Does this not contract supply, add to obscurantism and price?

    Cochrane in his blog is taking brave stands against broad over-regulation. Okay, I am against over-regulation. I sound very moral and smart. No?

    How about some specific recommendations for here and now? Like de-licensing lawyers?

  10. If there were no laws against lying in business, everyone would lie, for the simple reason that one lie could pay for a lifetime.

    Markets work only the penalties for lying exceed the profits to be gained. Even then, they do not work well.

    For example, your "thought experiment" was tried by Judge Easterbrook in DiLeo v. Ernst & Young, 901 F.2d 624 (holding there was no need to impose securities law obligations on accountants because they would check their behavior out of concern for their reputation).

    Of course he was proved wrong by Arthur Andersen/Exxon who within ten years lost trillions in stock values for investors and blew themselves up in the process, hurting tens of thousands of innocent people

  11. I have been around too long and am thoroughly confused by conflicting signals every decade. Free market, regulatory market , controlled market keeps coming and going. Point about saving is very valid but what do you invest in? There is an old saying in my part of the world-'invest savings in land or in gold.' You do not make much but you do not loose.

    1. Raja, you could lose with either gold or land. Depending upon when you invested. I have done well in my personal investing over the years by following a simple formula. Buy a lot during an economic down turn, you can buy land or stock in good solid companies, but be willing to hold it for a long time.

      Then when the economy is doing well, and you see a lot of accumulation of debt, and very high prices, then you know that a market correction is coming, then you sell what you bought in the lean times and buy something like gold which will hold value in a recession.

      It seems simple, and it is, what is important is to NOT become a victim of the herd mentality. Right now I am holding my gold, but buying stocks in solid, undervalued companies because even though we might get another dip in 2012, overall we are near the bottom of a market cycle.

      Remember it is impossible to predict the exact high and low points of any market, so don't even try. It is only necessary that you recognize the broad signs.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.