Reevaluating The Economic Analysis Of Credit And Bankruptcy

An oft-repeated defense of credit industry practices is that consumers act of their own volition.

According to this line of thought, credit card agreements, mortgages, and payday loans are merely contracts between rational, profit-maximizing parties with limited information. If the consumer misjudges and becomes subject to the onerous terms of the contract that she signed, c'est la vie; it’s just as plausible that the lender could have misjudged and earned only cents on the dollar in the consumer’s Chapter 7.

But legal and economic scholars working in the relatively new field of behavioral law and economics are beginning to undermine the tired logic of this industry defense. It turns out that, for reasons beyond their control, consumers act in ways that systematically depart from the rational choice model; that lenders knowingly exploit these vulnerabilities; and that the costs of the exploitation are borne not just by the individual consumer, but by family members, other consumers, and society as a whole. If all of this is so, the laissez faire approach is outmoded and regulation is justifiable.

A new paper offers an interesting example: credit industry marketing is calibrated to manipulate customers so that they will borrow beyond their needs and means. Average human economic actors suffer from various cognitive biases. Optimism bias, for example, causes people to underestimate the probability of experiencing a negative life event. Because of this, even people with full information regarding the prevalence of cancer, job loss, or divorce (all of which are associated with financial trouble and bankruptcy) will underestimate the likelihood of experiencing any of these things – and will borrow accordingly. The Harris/Albin paper contains several examples of advertisements in which lenders specifically exploit this human/market limitation to attract particularly vulnerable potential customers.

If credit consumers aren't the utility-maximizing actors the industry claims they are, what does it mean?

First, it means that the culture of blame rests on an empirically unsound assumption. If many or most people are effectively hardwired to be vulnerable, it is inappropriate to blame them for risky credit decisions. That, of course, is precisely what industry lobbyists did to convince Congress to pass the BAPCPA last spring.

Second, it raises important questions about our tolerance for the externalities of systematically irresponsible lending patterns. When borrowers extend themselves beyond their means, the cost is spread not just among the borrower and the lender, but to the borrower's family, the borrower's colleagues/customers/clients, and, in a welfare state like ours, to the universe of taxpayers. If the frequency with which borrowers default is a function of manipulative lending behavior, we may want to consider asking culpable lenders to shoulder more of the burden so that innocent bystanders have to shoulder less.

Harris and Albin propose intervening at two points in time: pre-transaction and during consumer bankruptcy proceedings. The former entails regulating modes and messages of lending advertising. The latter entails increasing the risks and costs for institutional creditors in personal bankruptcy proceedings.

For those of you who are inherently averse to increased regulation, consider the analogy to tobacco. For decades, tobacco companies, knowing full well that cigarette use (i.e. nicotine addiction) was not a rational choice, advertised their products in ways designed to exploit that biodetermined fact. When, through litigation and regulatory processes, it became clear that the industry had taken advantage of widespread vulnerabilities to the detriment of consumers and others, the government imposed regulations on cigarette advertising (e.g. no marketing to children) and enforced measures to shift the cost from taxpayers to the companies (e.g. huge settlements to offset the public health care burdens of lung cancer, emphysema, etc.). It’s time to consider a similar approach for manipulative lending behavior.

By Jason Spitalnick