Making Finance Work For Households

"Don't take this the wrong way, but I'm just trying to figure out how you're going to (expletive deleted) me."

Wall Street professional cited in Michael Lewis, The Big Short, Norton, 2011, p.95.

Last week, our friend, Harvard Professor John Y. Campbell, delivered the American Economic Association’s 2016 Ely Lecture, the group’s most prominent invited lecture. His topic—a central challenge for policymakers and practitioners alike—is how to make modern finance work better for consumers who lack understanding of the opportunities and risks they face. Professor Campbell discussed how we can take the lessons from behavioral finance and household finance—a relatively new field that he helped establish—to help households manage the choices that they face. The ultimate goal is to foster decisions consistent with economic rationality (hence his title, “Restoring Rational Choice: The Challenge of Consumer Finance”) while minimizing the costs of government intervention.

We take this opportunity to highlight a few important points from Professor Campbell’s presentation (text here; webcast here).

In many countries, people today rely on financial instruments to purchase homes, pay for higher education, and save for retirement. Yet, the complexity of modern finance is challenging even for the most sophisticated analysts. As a result, many, if not most, people are unable to utilize the tools of finance effectively. They suffer from financial “ignorance” (see table) that makes them prone to costly errors.

Types of Financial Ignorance

Source: John Y. Campbell, American Economic Association Richard T. Ely lecture, January 3, 2016.

Consumers who suffer from these behavioral distortions do not reap the full benefit either from existing opportunities to invest and borrow, or from the opportunities to reduce risk without the loss of returns. Examples abound. Many people fail to avail themselves of the opportunity to refinance their home mortgage when it is profitable to do so (optimal re-financing turns out to be a very complicated problem). Others are unaware of how much and how quickly the rate on their adjustable-rate mortgage can change, or the conditions under which they will pay bank overdraft or credit card fees. Many people unwittingly accept uncompensated (undiversified) risk in their portfolios. Even so, people lacking financial literacy may be quite confident about their acumen, making them exceptionally error prone. Finally, they can be naïve about the incentives of financial vendors to steer them to costly products. Unlike Michael Lewis’ experienced Wall Street professional in The Big Short (see the initial quote above), it may not even occur to them to ask how they are being taken advantage of. As a result, where the game is zero sum, the losses of the financially ignorant flow directly or indirectly to those who behave rationally.

Importantly, widespread financial ignorance probably contributes to wealth inequality. Wealthier households are more likely to participate in risky asset markets and to earn higher returns on well-diversified and rationally managed portfolios. While greater risk tolerance is almost surely a factor, it does not account for the key role of market participation, nor does it explain why some wealthy households don’t participate. At the same time, the acceptance of uncompensated risk in the portfolios of less wealthy households shows how financial ignorance can lead to lower returns and slower wealth accumulation.

Professors (and textbook co-authors) like us naturally hope that a combination of financial education and better disclosure can help cure the ills arising from financial ignorance. And, there is some hope on this front: for example, better disclosure of payday loan costs tends to reduce repeat borrowing (see here). However, compared to the widespread problems associated with financial ignorance, evidence for sustained benefits of financial training is limited.

That leaves more interventionist regulatory options, ranging from gentle “nudges” that impose little cost on rational, well-informed consumers to rules that direct or circumscribe consumer choice. Such nudges that impose costs only on those prone to financial error are appealing because they can change behavior at low social cost. The classic example is the introduction of “choice architecture” in company retirement plans that sets as the default option employee participation in a risk-appropriate, diversified, low-cost mutual fund. Making participation in a retirement scheme the default helps raise savings; making the default fund diversified and low cost limits the potential for exploitation of uninformed consumers; and allowing the fund to be risk appropriate (say, through a “target-date fund”  whose composition shifts automatically as a worker approaches retirement) avoids inefficiently allocating retirement funds to low-return assets (like money-market mutual funds) for decades. In this connection, the 2006 Pension Protection Act—which provided firms protection from loss in the case of “qualified default investment alternatives”—spurred the rapid growth of target-date funds, while undiversified investments in own-company stock have continued to decline. At the same time, it is easy for consumers to change the default option, so setting it to protect error-prone households imposes little, if any, cost on rational households.

In practice, however, effective nudges are typically hard to find, so that many issues in consumer financial protection cannot be addressed without at least considering more costly intervention. For example, it is hard to come up with an easy way to protect uninformed investors from conflicted vendors who wish to sell them costly, suboptimal assets for their retirement accounts. The U.S. Council of Economic Advisers has estimated the annual cost of conflicted advice at $17 billion. Yet, the Department of Labor’s proposal to impose fiduciary duties on brokers and others who advise on retirement savings will raise the cost of advice to both informed and uninformed consumers. Trying to balance these considerations—trading off protecting savers from costly mistakes resulting from conflicted advice against increasing the cost of financial advice to rational consumers—is both intellectually and politically challenging. Yet, there is no alternative to making such judgments on a case-by-case basis after a careful and transparent assessment of costs and benefits.

In some instances, policy responses to consumer financial protection run the full gamut from low to high intervention. For example, how can we protect unwary users of unsecured consumer credit from excessive costs while ensuring the supply of credit to those who understand the costs and wish to borrow? As previously mentioned, certain forms of disclosure help in the case of payday loans. At the opposite end of the intervention spectrum, the Military Lending Act caps the annual percentage rate on various forms of consumer credit to military families, while the Consumer Finance Protection Bureau (CFPB) is considering proposals that would limit loan rollovers by payday lenders.

Perhaps Professor Campbell’s most important message is that there are benefits from using economic research to assess alternative policies aimed at improving households’ financial decisions. Several years ago, Campbell et al. proposed a disciplined agenda for the new CFPB, culminating in the need to “evaluate both potential and existing regulations to determine whether interventions actually deliver the desired improvements.”

Academic economists have picked up this baton. To cite but one example (see here), researchers using a massive dataset covering 160 million credit card accounts determined that the Credit Card Accountability and Responsibility and Disclosure (CARD) Act of 2009—which capped credit card fees—lowered borrowing costs (especially for riskier borrowers) without diminishing the volume of credit. While the long-run impact of the CARD Act on the U.S. credit card industry is still to be assessed, the costs of the Act’s relatively aggressive intervention have so far proven limited.

So, what’s the bottom line? There are probably thousands of ways in which modern finance can be re-designed to improve the benefits to households, especially the less knowledgeable.  Many, if not most, of these innovations will arise naturally from competitive forces; others probably will require some public intervention.

With regard to the latter, we share Professor Campbell’s fundamental philosophy: any intervention should be designed to “restore rational choice;” must “rely on strong evidence rather than intuition;” should minimize costs imposed on those consumers who behave rationally; and should expose the tradeoffs between those who benefit from and those who are hurt by the intervention, allowing for transparent and informed policy decisions.

Economists can make a vital contribution in this effort.