How to Save Ourselves From the Irrational Economy

Harvard Business Review

November 19, 2008

by Marshall Goldsmith

MG: Not being an economist, but a behavioral scientist, I’ve asked Dan Ariely, the author of Predictably Irrational and the James B. Duke Professor of Behavioral Economics at Duke University, to answer these questions. Below is Dan’s take on the situation:

First, most of what we hear about is standard economic theory. Standard and behavioral economics are interested in the same questions and topics, e.g., people’s choices, effects on incentives, information’s role, etc. Behavioral economics, however, does not assume that people are rational. Behavioral economics takes into account how people actually behave, and uses this as its starting point. As a consequence, behavioral economists usually come to different conclusions about the logic and efficacy of almost anything, ranging from mortgages to savings to healthcare in both the personal and business realms.

Second, the market does not always fix our mistakes! It’s thought by many that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that people will often make the same mistake, and that these individual mistakes can aggregate in the market.
Take for example the sub-prime mortgage crisis. The market worked to make the aggregation of mistakes worse. Many people made the same mistake, and the market for these mistakes is what got us to where we are now.

When giving out loans, bankers assumed that their customers wouldn’t want to foreclose and that they would act accordingly. The first assumption was correct. The second assumption wasn’t. Consumers didn’t know what to do in order to make sure their house didn’t go into foreclosure.

The first problem is that it is extremely difficult to calculate the optimal amount that any of us should borrow on a mortgage. The second was the bankers’ introduction of interest-only mortgages. While these mortgages allow for flexibility, from my perspective, these loans would be ideal only if people were purely rational, which we’re not!

To begin, borrowers were told by banks and mortgage calculators the maximum amount they could borrow, not the optimal amount that they should borrow. Given a borrowing max of $400,000 with a regular mortgage or a borrowing max of $650,000 with an interest-only mortgage, would the average consumer borrow $400,000 with the interest-only mortgage and this way gain flexibility, or would they borrow to the new max?

Unfortunately, since we have a hard time figuring out how much we should borrow, people often borrow to the max, gaining no flexibility and in the process exposing themselves to a much higher risk in the real-estate market.
From a behavioral economics perspective, people are fallible and limited — but we are innovative and adaptable too. For instance, we build chairs, shoes, and cars to complement and enhance our physical capabilities. If we applied this same creativity to things affected by our cognitive limitations–insurance policies, retirement plans, and healthcare–we might design more effective policies and tools.

This is the promise of behavioral economics–once we understand where we are weak or wrong we can try to fix it and build a better world.

MG: Thank you Dan! Readers, if you would like to learn more about behavioral economics go to www.predictablyirrational.com. As always, any comments, reflections, or ideas you have will be much appreciated.