Can Housing and Credit be “Nudged” Back to Health?
Did human frailty cause this crisis? Several thinkers have come forward with a suggestion for improvements to fiscal policy that are based on fostering better decisions while preserving consumer choice, says HBS professor Jim Heskett. What should be done? What do you think? (Online forum now closed. Next forum begins January 7.)
The current global recession has, judging from responses to this month's column, many origins, among them housing and credit. All, of course, are traceable to human responses to both perceived opportunities and calamities, which in turn have been engineered by other humans. Given this, one might conclude that efforts to influence human decisions through "nudging" might be effective. However, respondents were far from unanimous in drawing this conclusion.
Adnan Younis Lodhi initiated the debate by saying "... the suggestion to limit 'temptation' (through "nudging" strategies—my insert) is an insult to individuals' intellect and tempering with human nature.... Only pain is the best teacher." Others agreed. Charlie Cullinane admonished, "Let the 'invisible hand' do what it does best!" Sondra Jacobson said, "No one knows what is best for another ... we have no choice but to let things be as they will, no matter how ludicrous and painful, until the understanding becomes knowledge." Tom Dolembo put it this way: "Nudge this back? Never ... As dumb as we are, we the people have learned that we can refuse to buy and prices will fall." P. Maxson asked, "Who gets to decide what the 'right' choices are?"
Ironically, some who questioned "nudge" strategies favored other perhaps more draconian solutions. Tony Evans said, "Generally, I like to see freedom for the individual to act...(but) regulation should be there.... Keeping 'excess' in check is an appropriate response by a civilized society." As Edware Hare put it, "Forget 'nudging.' We need to replace self-indulgence with self-restraint ... better education about economics and capitalism, harsher penalties for charlatans and thieves ...." Cole Woodson added, "The hope of nudging the economy in any direction is hoping for a miracle.... No securities of any type should even be allowed to be sold in the marketplace without government approval and some form of oversight." And Rahal Jayawardene commented, "... we need a carefully crafted, long term 'Social Engineering' campaign to transform the common mindset of people to foster a culture of thrift and prudence...."
Others favored and suggested nudges. Peter Ubel argued that "We human beings are imperfect decision-makers.... We are often harmed by our own worst instincts." Dan Wallace proposed: "I like 'nudge' solutions, and one approach here might be to provide a 100 percent mortgage interest deduction for people who put 20 percent down on a home, and ratchet the deduction down for people whose down payment is smaller." John Homan suggested, "... that the Federal Government give a 10 percent tax credit to the purchaser of a house and the purchaser pay it back ... over 20 years in equal installments with no interest."
Education in general as well as efforts to encourage simplicity and investor understanding seemed to go relatively unscathed in the discussion. But this suggests questions of: Just what kind of education? Who should be responsible for providing it? And what assurances would we have that investors and others would use it to their own best advantage as well as that of society? Would a "nudge" help here? What do you think?
Books with one-word titles are in fashion these days. Two current ones, Nudge and Enough, help us understand the roots of the current housing and credit crises as well as possible ways of avoiding them in the future. The first of these books, by Richard Thaler and Cass Sunstein, maintains that too much economic theory, formed by "Econs," is based on the behavior of homo economicus (economic man, someone with the knowledge and inclination to optimize solutions in his best interest, no matter how complex the choices) and too little on the actual behavior of mere humans, which is beset by "bounded rationality" (limits on the complexity we can deal with) as well as our limited self-control (inability to resist "temptation").
They advocate the use of "choice architecture" by businesses or governments to influence choices in ways that encourage choosers to make decisions in their best interest. They call it "libertarian paternalism." This involves utilizing "nudges" such as the wording of choices in ways that influence individual actions, designing default choices (in the absence of action) that do not penalize individuals, limiting choices to those that are more comprehensible, taxing detrimental choices, and providing full disclosure to better inform decision-makers. In short, the goal is to foster better decisions (paternalism) while preserving choice (libertarianism). Think of parents fashioning choices for children in ways that lead to acceptable choices instead of commanding them to do something.
Contrast this with what happened in the related housing and credit meltdowns. Borrowers were confronted with a growing myriad of mortgage options with provisions that made them difficult to compare, even for economic man, let alone for average consumers who may also have had too little self-control in their desire for a home and a mortgage. The resulting mortgages were then packaged in ways that John Bogle, in his new book, Enough, characterizes as creating "a modern version of alchemy," turning packages of poorly-rated mortgages into triple-A-rated collateral debt obligations, complete with supposed insurance against risk. The problem was that even financial experts couldn't understand their value or their risk, further impeding the intelligent choice so important to effectively functioning markets. Worse yet, the financial products were created by financial engineers motivated to make them complex and therefore harder to understand.
What is to be done? According to Thaler and Sunstein, it starts with recognizing that while "greed and corruption helped create the crisis, ... simple human frailty played a vital role." They suggest providing incentives to make financial products easier, not more difficult, to understand. This would involve, among other things, more disclosure about the real costs and risks of a loan. Further, they suggest in a recent Financial Times op-ed that "government and the market should try to deal with temptation" (our limited self-control) by, for example, requiring that families accumulate some savings or be willing to shorten the term of the loan in order to qualify for refinancing. These recommendations fall at the intersection of financial and social engineering. They raise the question of whether housing and credit can be "nudged" back to health in this manner or whether there is some better approach. What do you think?
To read more:
John C. Bogle, Enough: True Measures of Money, Business and Life (New York: John Wiley & Sons, Inc., 2009)
Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven: Yale University Press, 2008)
Richard Thaler and Cass Sunstein, "Human frailty caused this crisis," Financial Times, November 12, 2008, p. 11