“We are all behaviorists now.”

1. Comment on Alan Schwartz, “Consumer Regulation and the Rationality Assumption”Dan KlermanUSC Law SchoolFaculty WorkshopUSC Law SchoolNovember 2, 2012

2. “We are all behaviorists now.” • Alan’s paper is not a rejection of behavioral economics • Alan accepts that human beings are plagued by biases and that, if social scientists fully understood those biases, law should craft responses which took those biases into account • Alan’s paper is a plea for caution in implementing solutions inspired by behavior economics • 1. People behave differently in real world than in psychology experiments. • 2. Interaction between cognitive biases is unknown. • 3. Competition may protect biased consumers. • 4. Presumption against prohibitions or mandatory rules in “liberal state.” • Because regulation restricts choices • Including choices of sophisticated persons not subject to biases • Preference for disclosure over prohibitions or mandatory terms • Don’t impose prohibitions or mandatory rules until theoretical and empirical issues are fully worked out • 2 responses • Analysis of consumer credit • Is presumption against regulation justified?

3. Consumer Credit & Cognitive Biases • Simplification of ideas in Oren Bar-Gill (2004, 2009) • Heterogeneous consumers • Some sophisticated • Some unsophisticated • Overly optimistic about downward trend in interest rates • So expect to refinance in a few years at lower rates • Market responds with mix of products • Fixed rate mortgages (preferred by sophisticated borrowers) • Loans with teaser rates (preferred by unsophisticated) • Predictable consequence is that unsophisticated borrow too much • If borrow a little too much • unsophisticated consumer’s welfare is reduced • because land up with higher payments than projected • Banks don’t make abnormal profits • Because competition between banks for unsophisticated borrowers causes interest rates to fall to zero-profit level • If borrow a lot too much, banks fail and country enters recession

4. Alan’s Arguments Applied to Consumer Credit • 1. People’s behavior in real-world is different from behavior in lab • Not relevant here. Over-borrowing by unsophisticated borrowers is real world phenomenon. • 2. Biases interact in complicated ways • People may have status quo bias or be overly risk averse • But clear that these did not completely offset optimism and other biases • Maybe consumers have learned from the Great Recession • So no longer optimistic • But this is a very expensive way for people to learn • Children of Great Depression also learned to be more cautious financially. Later generations forgot. • 3. Competition protects unsophisticated • Schwartz & Wilde (1979) present elegant argument for why competition will sometimes protect unsophisticated consumers. • But assumes that sophisticated and unsophisticated consumers buy the same products. • In credit markets, sophisticated and unsophisticated buy different products • In fact, competition requires profit-maximizing firms to exploit biases of unsophisticated consumers • Otherwise they will lose all sales in that segment to less scrupulous firms.

5. What About Disclosure? • Already have TILA disclosure of APR • Lots of problems with APR • Bar-Gill (2009) proposes reforms of APR, but unlikely to be effective • Problem is that APR depends on probability of refinance • Low teaser rates are great for consumers who are going to refinance before higher rate kicks in • If base APR on assumption of no refinance, then consumers who plan to refinance ignore APR • If base APR on assumption of early refinance, then consumers who are overly optimistic about downward trend of interest rates base their borrowing decision on short-term APR • But then they are saddled with higher than expected payments when they are unable to refinance at lower rates • If give consumers menu of APRs based on different assumptions about refinance • Probably too confusing to be useful • Overly optimistic consumers would base decision on implausible assumption of quick refinance. • So wouldn’t help.

6. Prohibition of Teaser Rates • Plausible policy response is to ban teaser rates • Protect unsophisticated borrowers from optimism about future interest rates and likelihood of refinance • This is “mandatory” rule, not disclosure • Costs of prohibition • Teaser rates are good for a small number of sophisticated consumers who correctly anticipate higher future income or who want to gamble on falling interest rates • How many such consumers are there? • How big a loss in social welfare from denying such consumers this choice? • If there are many sophisticated consumers who would benefit from teaser rates, could allow qualified persons to get teaser rates • Like special rules for sophisticated investors in securities laws • Other costs?

7. Cost-Benefit Analysis of Regulatory Delay • Is it appropriate to delay regulation until theoretical and empirical issues are fully resolved? • If we need to wait, regulation will be decades away • Is delay justified by economic analysis? • Need to weigh costs of imperfect regulation against benefits • Benefits • Block welfare-reducing transactions • Protection of unsophisticated • Learn about human behavior and design of better regulation • Prevent recurrence of Great Recession • Costs • Blocking beneficial transactions • Unintended, unanticipated consequences • Depending on regulation at issue, costs may be trivial in relationship to benefits • Or is Alan arguing for delay based on non-economic, non-consequentialist grounds?

8. Conclusion • Alan is certainly right that there is a lot more to learn before we can use behavior economics with confidence to regulate • But not clear that means that we should not regulate or just regulate using disclosure rules • Failure to regulate can have even greater consequences • Cost-benefit analysis of regulation must take into account benefits of regulation as well as uncertainty about its effectiveness • Presumption in favor of no regulation may be unwarranted • Costs of failure to regulate consumer finance transactions may outweigh benefits