Baseline Scenario Today -- Wonkish But Good

The Baseline Scenario
Traditional Chicago Economics Under Pressure: Beyond The Thaler-Posner Debate
Posted: 29 Jul 2009 04:38 AM PDT
Richard Posner is against the proposed new Consumer Financial Protection Agency (CFPA). This is, of course, not a surprise. Posner has always been an articulate advocate of the view most often associated with economics at the University of Chicago: market-based outcomes are invariably better than the alternatives, and anything that interferes with consumer choice is a bad idea.
Posner wraps this opposition to the CFPA into an odd attack (near the end of his WSJ op ed) on the personal decision-making abilities of Richard Thaler – a leading economist on consumer choice, misperceptions, and mistakes. (More on Thaler here.)
Thaler, also of the University of Chicago, hit back hard yesterday. He is right that Posner mischaracterizes the CFPA proposal, and points out that his agenda – and that of Cass Sunstein, formerly of Chicago and now a czar in the adminstration – is simply to provide consumers with a framework for better decisions. He implies that Posner defends defective baby cribs and their equivalent.
I would go further.
Think of it this way. We’ve learned a great deal about how consumers make decisions, including when they get things right and wrong. Behavioral economics, marketing, and related social science have made big strides (e.g., follow the work of Dan Ariely).
But all of this research is also available to companies. Perhaps they knew some of this before from trial-and-error, but there is no question that many of the techniques corporate America uses – and we as consumers find ourselves “up against” – is cutting edge manipulation of our decisions.
We worry a great deal about how corporations lobby to shape their regulatory environment. This is a struggle that is at least 150 years old in its modern form (e.g., railroad concessions), and much older if we think about powerful people bribing their way into advantageous relationships with the state.
In addition, companies now have powerful new tools to shape how we perceive our potential choices. Some of these tools might be good for us also – I’m open to argument on this. But within some particular spaces, including financial products, it’s clear that many of these “innovations” are actually clever ways to extract value from consumers.
Traditional Chicago economics always had its weaknesses – particularly when you focus on the fact that the “rules of the game” are often shaped by the more powerful. Thaler and Sunstein (and others) are trying to modernize this view more generally, while keeping the element of consumer choice as central.
But if the balance of power has shifted – due to technological innovation in social science – further towards corporations and away from consumers, then the task ahead is much harder.
Unless companies are compelled to keep their offerings “simple enough to understand”, we will face repeated rip-offs and crises – both macroeconomic and personal – arising from our financial sector.
By Simon Johnson

More on Rescissions
Posted: 28 Jul 2009 06:12 PM PDT
For those interested in the issue of health insurance policy rescissions, Slate also had a story yesterday, only with a lot more detail and links than mine (but without the clever comparison to financial services “innovation”).
Also, Taunter wrote an insightful post about rescission, expanding on a comment he left on this blog. He drives home a point I thought I made in my original post, but maybe wasn’t very clear: if 0.5% of policies get rescinded, that means that far more than 0.5% of insureds who really need insurance get their policies rescinded, because the insurers are targeting those policyholders who develop expensive illnesses. I said, “insurers only try to rescind policies if you turn out to need them; so the percentage of people who lose their policies when they need them is even higher.” Taunter puts numbers behind that, and they turn out to be potentially scary.
He also has a great analogy to underage gambling which I will reproduce here:
Years ago I was walking a casino floor with a casino executive. . . . [T]here we were in the middle of acres of blinking lights, with absolutely no one making sure that underage kids weren’t walking up to a slot machine. Indeed, they don’t card for the table games.
The executive told me you are free to play if you are underage, you just aren’t free to win. You can sit down and pump your money into the slots, and if you look presentable you can drop some chips on blackjack or craps. However, if you should happen to start winning, the pit boss or security team will come over and check your ID. The house edge is 100%.
By James Kwak