Human frailty caused this crisis

By Richard Thaler and Cass Sunstein

Published: November 11 2008 19:46 Last updated: November 11 2008 19:46

Mea culpas are rare these days. In a debate with John Kerry in 2004, President George W. Bush fa­mously could not name a single mistake he had made in his first term. So it is both noteworthy and commend­able that Alan Greenspan, the former US Federal Reserve chairman, fessed up that he had failed to anticipate the financial crisis.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief,” he said. Mr Greenspan had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Yet that is what happened. As Mr Greenspan says of securities based on subprime mortgages: “To the most sophisticated investors in the world, they were wrongly viewed as a ‘steal’.”

Why did Mr Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? We think their mistake was to neglect the role of human nature. To prevent future catastrophes, regulators should focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioural economics: bounded rationality and limited self-control.

The standard (non-behavioural) econ­omic model has greatly influenced regulators. In that model, economic agents (econs for short) choose optimally, no matter how hard a problem they face. They play chess as well as they play tic-tac-toe. The problem with this approach is that the world is populated by humans, not econs. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality.

This brings us to an aspect of the financial crisis that has not received the attention it deserves: the financial world has become more complex in the past two decades. Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them and a low initial monthly payment can be a misleading guide to total costs (and risks). A main cause of the mortgage crisis is that borrowers did not understand the terms of their loans. Even those who tried to read the fine print felt their eyes glazing over, especially after their mortgage broker assured them that they had an amazing deal.

Yet growing complexity on the borrowers’ side was trivial compared with what was going on at the banks. Mortgages used to be held by the banks that initiated the loans. Now they are sliced into mortgage-backed securities, which include arcane derivative products.

Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But, as Mr Greenspan now ­concedes, even these sophisticated investors got things badly wrong.
The second problem involves self-control. Econs do not suffer from self-control problems and so “temptation” is not a word that exists in the economists’ lexicon. As a result, regulators have not thought much about the problem. But when the dessert cart comes by, we humans often cave in. The next thing we know, we are fat. This crisis was fuelled by the seemingly irresistible temptation to refinance the mortgage rather than pay it off. Falling interest rates, rising home prices and aggressive mortgage brokers made re­financing (and second mortgages) seem like the apple in the Garden of Eden. When home prices fell and interest rates increased, the party ended.

Regulators therefore need to help people manage complexity and resist temptation. A potential response to complexity would be to require simplicity – for example, by allowing only the standard 30-year fixed-rate mortgages. This would be a big mistake. Eliminating complexity would stifle innovation. A TiVo is a more complicated product than a VCR, but it is also better.
A superior approach is to improve disclosure. One reason a TiVo is better than a VCR is that it is easier to use. Regulators can reduce the chances of a future meltdown by making it easier to understand financial products. Agg­ressive steps should be taken to imp­rove disclosure – for example, with mortgages, fine-print disclosure should be supplemented by machine-readable files enabling third-party websites to translate hidden details of the terms. Mandatory transparency for investment banks and hedge funds would also help.

The government and the market should try to deal with temptation. We hope that lenders will ask families to have done some saving in order to qualify to buy a home. Conscientious lenders could also nudge people to get off the refinancing merry-go-round, by suggesting that the term of the loan be shortened when a loan is refinanced. More ambitiously, private and public institutions could try to reintroduce an old social norm: try to pay off the mortgage sooner rather than later, and at the latest by the time you retire.

Greed and corruption helped create the crisis, but simple human frailty played a vital role. We will not be able to protect against future crises if we rail against greed and wrongdoers without looking in the mirror and understanding the potentially devastating effects of bounded rationality and limited self-control.

Richard Thaler is professor of behavioural science and economics at the Graduate School of Business, University of Chicago. Cass Sunstein is Felix Frankfurter professor of law at the Harvard Law School. They are the co-authors of ‘Nudge’ (Yale University Press)

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