Comment on Alan Schwartz, “Consumer Regulation and the Rationality Assumption” Dan Klerman USC Law School Faculty Workshop USC Law School November 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