Monday, February 06, 2012

Cochrane on consumer financial protection

The John Cochrane shadow-blogging continues...

Cochrane has two posts up about consumer financial protection. The first is about the negative impacts of anti-usury laws:
Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit.  And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses... 
Here are just a few of the fun facts.
  • Tighter usury laws led to less credit. People didn't easily get around them.
  • Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade. 
  • Usury laws only affect the growth of small firms. Big firms do fine...
Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...
This seems right to me (and Cochrane cites some research to back up these points). Anti-usury laws don't seem to have worked out too well in the past, either in terms of boosting economic performance or creating a more equitable society. Another downside of such laws, which Cochrane doesn't mention, is that anti-usury laws can lead to the proliferation of mafia loansharks.

The rationale for consumer financial protection in the U.S. - the main argument in favor of the Consumer Financial Protection Bureau - has always been that many modern financial products are too complex for consumers to understand (leading to either people being tricked, or markets breaking down because people fear being tricked). But high interest rates are not complex. They are very simple. People do not need government help to understand high interest rates. This means that the CPFB should ideally focus on complexity (and on behavioral effects that allow companies to repeatedly deceive consumers), not on the tightness of lending standards in general.

Cochrane's second post argues that since regulators are subject to behavioral biases, the CFPB will be no better at evaluating financial products than are the consumers that the agency is meant to protect:
Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook. 
Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?  
Sure, the market will get it wrong. But behavioral economics, if you take it seriously,  predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions. 
More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong. 
This does not seem right to me. I don't think that behavioral theories apply to regulators in the same way that they apply to the people that the regulators are supposed to protect. 

For example, many behavioral theories rest on the idea that consumers are overconfident and exhibit considerable self-attribution bias. Regulators, when evaluating a financial product being sold by Company A to Consumer B, will presumably suffer from these same biases, but not in the same way. An overconfident consumer may say "Housing prices will always go up," even if a dispassionate analysis says that they won't. A regulator, by contrast, may be overconfident in general, but she won't be overconfident about the price of the consumer's house! 

So, just saying "regulators are people too" doesn't prove anything. The point of behavioral economics is not just to say that "people make mistakes"; it's to point out what kind of mistakes people make, and when.

(I should note that variants of this argument - "Governments make mistakes too!" - are extremely common among opponents of regulation. But just to say "Governments make mistakes, therefore we shouldn't rely on government for things" seems very wrong to me. We need to study what kind of mistakes governments make, and when. Otherwise we risk making the perfect the enemy of the good.)


  1. "For example, many behavioral theories rest on the idea that consumers are overconfident and exhibit considerable self-attribution bias."

    Right! Which is why Cochrane is wrong about usury laws too. People, especially desperate ones, are hopelessly optimistic/superstitious about their future prospects. Borrowing at hundreds of percent annually from payday lenders is not a strategy to return to solvency. It's the end. And yes, the mafia is bad. That's why we have cops and a criminal justice system.

    If you want to solve the public choice problem, just get governments out of the debt contract enforcement business. Credit scoring systems and collateral ought to suffice to provide sufficient liquidity. Maybe we'd get less debt to boot!

  2. @K


    ...adding, to argue against regulating lending is straight-up perverse. The mafia loan shark is a bad actor, and so, in my estimation are the pay-day lenders. Difference? Hard to find, other than breaking legs versus breaking a down-on-his-luck ignorant slob's future.

  3. James Edwards2:44 AM

    Obviously Cochrane never asked the advice of an impartial friend about a serious life decision.

  4. We would not need consumer protection laws if people understood financial products. The financial crisis proved that most Wall Street bankers did not not understand the products they were dealing in.

    Some financial products should be banned (for example, "Ninja" home mortgages, pay day loans and credit default swaps) simply because their track record shows they are too dangerous to financial well being to be permitted.

  5. Bentham makes some of these points brilliantly in his Defense of Usury:

    The first five chapters of his An Introduction to the Principles of Morals and Legislation are also worth reading:

  6. Noah,
    You said: We need to study what kind of mistakes governments make, and when. How about the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act? I'm not sure the Act was well intentioned, but the unintended consequences of the consumer protection part are working just swell for the creditors.

  7. "More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong."

    Of course that argument founders on the fact that governments created the free market conditions. Free markets did not arise spontaneously.

    And other generalizations in that statement are also ludicrous. Are all governments equally wrong about every thing they attempt?

  8. James Edwards: "Obviously Cochrane never asked the advice of an impartial friend about a serious life decision."

    Like what? Should I write this stupid blog post?

  9. Noah, I agree: I can't see any reason why firms in competitive markets wouldn't exploit consumers' behavioural biases to the full. Think about it: which is more likely to set prices at $X.99, taking advantage of consumers' perceived misperception, a government regulator, or a competitive firm? Definitely the competitive firm.

    Regulators do institute things that have perverse effects - e.g. some have argued that minimum payments on credit cards act as an anchor, lowering average payment amounts - but that's in response to lobbying by industry.

  10. I know one guy who would disagree with you and Cochrane on usury:

    "(Adam)Smith returns to the subject in Book II. The permitted rate tends to be related to its general market price available to ‘those who can give the most undoubted security’, and the anti-usury rate ought to be fixed somewhat above the market rate (if fixed below the market rate it would choke off lending and ruin ‘honest people’). He illustrates the British example where the rate of interest paid on government bonds was 3 percent, and private people with good security pay 4 to 4.5 per cent, with the legal rate (maximum) was 5 per cent, which was ‘perhaps as proper as any’ (WN II.iv.14: 357).

    He further observed that if the legal maximum was ‘so high as eight or ten per cent’ then the ‘greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest’, adding that ‘Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition’. In consequence a ‘great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which are most likely to waste and destroy it’. Contra-wise, where the legal rate is fixed ‘but a little above the lowest market rate, the greater part of the ‘capital is thus thrown into the hands in which it is most likely to be employed with advantage’ (WN II.iv.15: 357)."

    If behavioral economics does demonstrate that people are systematically overly optimistic then it's not clear that limits on interest rates are necessarily a bad thing. If a prospect theory projects the poor are likely to be below their reference point and, therefore, systematically risk seeking, then interest rate limits may be warranted.

    I'd generally prefer to use those reasons to rebalance collection and bankruptcy to a greater shared risk between lender and borrower. Any case where the lender's interest is overprotected either through bail outs or onerous collection provisions they are likely to exploit these biases extensively (see for profit colleges).

  11. Phil Koop8:57 AM

    "But high interest rates are not complex."

    To a point. If I want to borrow $100 for 2 weeks, it is easy to decide whether paying $5 or $6 in interest is a better deal. But comparisons across different temporal bases are much harder.

    Suppose my actual alternatives are to roll over a 2 week loan for a year paying $5 each time, or to contract for a term loan paying $200? Many people would get this wrong, would they not? They would reason that 26 x $5 = $130 < $200, forgetting that each $5 interest payment is in effect borrowed money.

    (This relates to K's point about overconfidence, of course.)

  12. Phil Koop9:04 AM

    More generally, though, I thing your argument is correct. Financial institutions systematically design products to exploit the behavioral biases of consumers. Therefore, the errors that consumers make are biased. Regulators may make many errors, but there is no reason why these errors should be strongly biased.

  13. dilbert dogbert9:04 AM

    I'll have to do more reading on Anarchist Thought, but, it seems to my poor pea brain that the simplest interpretation of Cochrane's ideal government is anarchy. Or as they say on the blogs: WASS

  14. Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail?

    I see Cochrane's brand of thinking as having two major weaknesses. One, it tends to be a priori, based on ideas rather than actual experience. Two, it's intensely pessimistic, boiling down to "it can't be done."

    As Mike Huben said, there isn't any free market in the absence of government. Add to that, private actors (think large businesses) have an intense bias in favor of destroying competition, not encouraging it. And once they attain sufficient economic (and political) power they often succeed in stifling actual competition.

    The bias here is a perception bias. Cochrane sees virtuous market characteristics and looks away from or discounts non-virtuous market activity; and he does the reverse when it comes to gov't.

  15. "But high interest rates are not complex. They are very simple. "

    Anybody who says this should really not be posting on the subject - have you ever heard of 'universal default', for example?

  16. Yea, usury laws are terrible for utility. Much better is to allow unmitigated credit apparatis to double the size of an already massive sector of the debt markets in six years- let's say, I don't know, mortgage debt- and watch that economy smoke! Not only that, but we get to watch the smoking wreck of its former self thereafter. Advantage: fresh water.

    Words fail. Modern economics is the Asberger's Science. Truly. One permitted entrance only after you've demonstrated complete indifference to reality.

  17. "But high interest rates are not complex"

    What world are you living in?

    How come, sometimes even rather well educated people, cannot work out the implications of taking some online “easy loan” with 30 % interest? No idea, maybe behavioral economics can give us a answer, but that a lot of people do should be pretty obvious to anyone engaging with the real world. If you are the kind of person that has to pay 30 % interest to get a loan (or would be willing to pay 30 %), chances are that you would benefit from having a hard time to acquire one.

  18. PS:
    Sorry, I did not read the comments before posting, and did not mean to beat the dead horse.

    What I should have written:

    What is wrong with economists? What kind of bias is it that makes, even seemingly reasonable economists, to time after time make the very same errors as you would expect to hear from nutcase market fundamentalists?
    That a lot of people fail to plan their private economy, and that high interest loans is a very common trap, really is obvious to anyone not living under a rock. And is there even one single example of a successful company that got started due to easy loans (and could not have acquired a regular loan under better terms)? Still, I would guess that in general, even very progressive economists would take your comment about interest rates as a given.

    No wonder we ended up where we did.

  19. You have to be specific about what types of usury laws. Lowering an interest rate cap from 2% to 1% surely will hurt long term growth substantially, but lowering it from 1,000% annually, as many payday loan shops charge, to 15%? This should help growth, by ending crushing indentured servitude and hopelessness in poorer neighborhoods.

    And yes, some people are far more mistake prone than others. Ever heard of crack addicts, smokers, payday loan slaves? It does make a difference, Cochrane, that the expert knows the tendency to bias exists, so he can guard against it, and be trained to guard against it. And the free market historically does not have better outcomes than government when the externalities are big enough, when there's natural monopoly,… Almost always some government role increases efficiency, growth, total societal utils. That's what history shows. Look at what one of our most esteemed growth economists Paul Romer writes.

    And clearly positional externalities are so crucial (see Frank's The Darwin Economy for details)? Why is it so rare for economists to think about this? If your neighbors inflict constant financial stress on themselves with high and ultra high rate debt to buy more expensive clothes, cars, furniture, etc., this puts a lot of pressure on you to become crushed by debt to not look like a looser, and not be able to attract the opposite sex. If no one can strangle themselves with these payday loans, pawn shops, and rent to owns, pretty much the whole community is better off.

    And just because the interest rate is clear doesn't mean that consumers have close to the numeracy to understand how crushing it can be, the immense power of compound interest over time. It's like private student loans, which can never be escaped in bankruptcy (with very rare exception), 15% might not sound that bad. Few 18 year olds will realize how quickly that doubles and quadruples a large loan, how easily it can grow to the point where it can never be paid, and you're a debt slave for life, before your life really even got started, with anything you ever gain in life at risk of being ripped away by the predatory lender.

  20. Cochrane's whole attitude that less credit is always a bad thing shows that he's never been crushed by debt, and has little empathy for those who are.

    I see this whole thing as being common with extreme libertarians. Freedom man! You don't give up even a micro spec to stop horrible widespread suffering and loss. Because they're doing fine in life and are at no risk of ruin.

  21. The following is from a 2007 floor statement from Senator Dick Durbin (I'm sorry, but the link to it is no longer up):

    "Mr. President, I would like to tell you about Connie Martin from Sycamore, IL. Connie's son decided to go to culinary school in Chicago 5 years ago at the age of 25. To pay for tuition, he borrowed $58,000 in private loans from Sallie Mae at 18 percent interest. His first payment was $1,100 a month--his entire monthly salary at a downtown eatery where he worked after graduation. His loan balance, including government-backed loans, is now $100,000. Connie's son has been working hard, and she and her husband have been trying to help him make the payments. I worry for borrowers like Connie's son who can't start over and will have debt that will likely haunt him for the rest of his life."

    So, everyone's equally likely to make the same mistakes, so government can't help? Are you equally likely to make the life ruining mistake Connie Martin's son did, Dr. Cochrane? Is your son? Do you think no expert, no matter how educated, mature, and trained, could have seen this predation any better than Connie Martin's son could?

    And how much do you really care?

  22. Also, at this point, why should we give one ounce of credibility to Cochrane? At this point, throwing rotten tomatoes is the proper response.

  23. Anonymous11:52 PM

    You write: "I should note that variants of this argument - "Governments make mistakes too!" - are extremely common among opponents of regulation. But just to say "Governments make mistakes, therefore we shouldn't rely on government for things" seems very wrong to me. We need to study what kind of mistakes governments make, and when. Otherwise we risk making the perfect the enemy of the good."

    This is correct. Fortunately for you and your blog readers, serious economists have been studying exactly these issues for many decades.

  24. Usury laws are great when combined with monetary policy that keeps rates - both long and short term - at lows, as not to drive credit into the black market.

    High rates force people into more speculative and less sustainable investment. See Keynes & Smith!

  25. Anonymous9:42 AM

    Economists are kind of weird because they are stuck in a math envy trap; they aren't self confident enough to realize that math isn't always appropriate.
    It reminds me of the old joke: an economist and an engineer (male) are at a party, and the engineer says, lets walk over there and chat up that babe.
    the economist says, it isn't worth it, because once we walk half way, half the distance still remains, and once we walk the next half, half still remains..and we will never get there

    and the engineer says, that maybe true, but we will get close enough for some practical damage

    also, you have to realize, the idea that one person can write a blog is ludicrous; maybe if you are P Krugman, but almost no one has enough energy and brain power and writing skills to write a column each day, and if you don't have new stuff each day, your blog dies.

    That is why the one person blog is sort of a self contradictory term; Thoma handles this by just reposting, and deLong handles this by a lot of quotations, and Krugman is just a log better then anyone else

    the idea that Noah, or almost anyone (not to pick on him) has enough interesting stuff to write a column a day, or even a column a week, is pretty amazing

  26. Tacitus10:56 AM

    It's good to realize that every so often the lawyers actually have something to contribute to an economics conversation, not just something to learn. To wit: there is a big, fat, practical reason why John Cochrane's criticism of usury is utterly irrelevant to any critique he may make about the effectiveness of recent consumer protection initiatives, and it is that the big recent US consumer protection laws (federal and state) are overwhelmingly NOT usury laws. They don't set maximum interest rates, they don't invalidate loans made above those maximums, they don't do any of the things that made old-fashioned usury laws the target for criticism from Bentham on. Old laws still on the books establish usury rates in many states, sure -- but these are typically riddled with exceptions that have the effect of giving wide latitude for creditors to respond to market forces in pricing credit.

    The Consumer Financial Protection Bureau (presumably what is being alluded to by the picture of the exploding toaster oven, post-explosion, this being an homage to Elizabeth Warren's famous analogy) is a perfect example. The Dodd-Frank Act doesn't give the CFPB the power to establish usury rates in the traditional sense. It does give the CFPB the power to establish things like interest rate triggers for additional disclosures, or prohibitions on particular terms and conditions. But that is garden variety market regulation -- and by the way something that has been on the federal statute books with respect to home loans at least since 1994, when federal law banned prepayment penalties for certain home loans at unusually high interest rates.

    So, Noah, and you other economists reading Noah's blog, keep up the good work poking economic holes in Cochrane's critique of usury, by all means. But remember that as a foundation for a meaningful argument about the framework of current law and public policy, it is all a red herring.

  27. @Tacitus - yes!! If only statutes and regs were more readily available and easier to understand, people would be having very different arguments about them.