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Richard H. Thaler and Cass R. Sunstein

Economic policy for humans

Email|Print|Single Page| Text size + By Richard H. Thaler and Cass R. Sunstein
April 17, 2008

IN THE past 20 years, there has been a growing interest in cutting-edge research that has come to be called "behavioral economics." In behavioral economics, the robot-like creatures who populate standard economic theories are replaced with real human beings.

If the next president appointed a behavioral economist as the chairman of the Council of Economic Advisors, what sort of advice should we expect to hear?

Let's consider the mortgage crisis as an example.

In a standard economic analysis of the mortgage market, the working hypothesis is that borrowers are capable of choosing the best mortgage for their financial circumstances.

This assumption might have been reasonable back in the days when nearly every mortgage was a simple 30-year fixed-rate loan. It is now preposterous.

In today's markets with variable rates, prepayment penalties, balloons, and so forth, even economists have trouble sorting out which mortgage is best. It doesn't help that the market has some pushy mortgage brokers who get paid based on the profitability of the loan.

Many borrowers who are now in trouble made poor choices and took on loans they could not really afford. Other borrowers were just speculators, and were hoping that home prices would continue to rise. Policies aimed at helping those in trouble now should be targeted at the first group, not the second.

From the standpoint of behavioral economics, two kinds of policies make good bipartisan sense. First, some aid should be offered to the homeowners who were bamboozled into taking bad loans. Congress is considering several such proposals, in which the government would offer guarantees to lenders who agree to rewrite troubled mortgages.

Critics of such a plan call it a "bail-out." But if the program is limited to owner-occupied homes, the adverse effects will be limited. Stabilizing the real estate market is a legitimate government goal.

Far more important, it is crucial to design policies that will prevent similar problems in the future. Behavioral economics provides specific suggestions not just for mortgages but also for credit cards, cellphone plans, prescription drugs, and student loans. The basic idea is that for complex financial products, the government should strive for what might be called "simplified transparency."

The Truth in Lending Act, enacted in 1968, was a good start along these lines. That law required lenders to report interest rates in terms of Annual Percentage Rate, so that borrowers could easily compare the costs of different loans.

The problem now is that both mortgages and credit cards have rates that vary over time, and numerous other fees that are difficult to understand. It has now become virtually impossible to offer a simple, one-page, plain-English document that explains all the relevant features of a mortgage or credit card.

The best response would make use of modern technology to create a Truth in Lending Act for the 21st century.

In brief, government would achieve simplified transparency by requiring all lenders to provide borrowers with an electronic file that contains, in standardized form, information on every feature of the contract.

Instead of fine print, there would be electronic information. And because disclosure would be standardized, consumers could easily compare one mortgage, and one credit card or school loan proposal, with many others.

Now, you might wonder, how do these electronic files, even if standardized, help us mortals who have trouble learning how to record a TV show on a VCR? The answer would come through the market.

As soon as the government required electronic disclosures, websites would quickly emerge to help people in the task of comparing offerings. A borrower would go to "mortgageevaluator.com," upload the relevant quote, and receive an easy-to-understand analysis of the loan they have been offered, plus other loans that they might consider.

The same approach could be used in other domains, from cellphone calling plans to Medicare prescription drug coverage.

This proposal illustrates the essence of good policymaking from the standpoint of behavioral economics. Government does not tell people what to do. Instead, it tries to improve markets by making it easier for busy people to make good decisions.

Richard H. Thaler and Cass R. Sunstein are authors of "Nudge: Improving Decisions About Health, Wealth, and Happiness."

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