We’re back on the topic of consumer mythology. Here, we address in greater detail the inferences raised by the experimental work of cognitive psychologists and other behavioral decision researchers (BDR to the cognoscenti) regarding consumers’ borrowing and default behavior. (We say inferences because few of these experiments directly tackle the psychology of debt). Our primary insight in The Myth of the Rational Borrower was that the decision whether to pay with cash or to borrow (by using a credit card or some other means) is a complex one — so complex that a law degree, a calculator, a present value table and a crystal ball would come in handy when resolving it.
The shortcomings of consumer borrowers come in three flavors: (1) cognitive limitations; (2) heuristic biases; and (3) anomalous preferences.
Cognitive Limitations. First, we think that most (OK, OK nearly all) consumers simplify borrowing decisions by reducing the many comparisons at stake to one simple question: Can I afford the minimum monthly payment? While normally heuristics — aka rules of thumb — get us successfully through the day, this one (and a few others) may create problems.
Heuristic Bias. Shortcuts are fine, but the psychological literature on framing suggests that some of these heuristics may hide biases in decisionmaking that render consumers easy marks. For example, the availability heuristic (focusing on an easy or "available" measure) leads many consumer to anchor their consumption and borrowing decisions around the minimum payment. Optimism bias may cause consumers to overestimate their income in the next period, or underestimate their need for borrowed money in future periods. Cognitive dissonance may cause consumers to underestimate credit card use so far this month, or to ignore the amount being spent on finance charges.
Anomalous Preferences. The most interesting to us, or at least the concept that produced the biggest "aha" when we learned of it, is time inconsistent preferences. Consumer borrowing decisions involve a choice between present and future consumption. This intertemporal choice depends on the relative weight attached to future consumption versus present consumption – the consumer’s discount rate. Economists assume that the discount rate is consistent over different time periods. Apparently, however, individuals do not apply a single discount rate over their lifetime. Richard Thaler asked respondents to specify the amount of money they would require in {one month/one year/ten years} to make them indifferent to receiving $15 now. The responses {$20/$50/$100} imply a wildly divergent, indeed paradoxical range of average annual discount rates over the three periods {345 percent/120 percent/9 percent}. This effect may cause consumers to ignore very high lending costs on small amounts or for short time periods. For real world examples think of pay day lending (or health club membership).
What’s the implication? The biases identified by BDR consistently suggest that flesh-and-blood consumers will borrow more than a rational actor would. It also suggests that less than rational consumers may make borrowing and consumption decisions that do not accurately reflect their true (whatever that might mean) preferences.
In our view the possibility that consumers are less than rational, when married to the changes in lending technology described in our previous post, provides a plausible explanation for the confluence of highly profitable consumer lending and a skyrocketing bankruptcy filing rate between 1980-2005.
(Okay, we’ve promised some empiricism. We’re getting there.)