Patrick McHenryChairman

Washington, June 3, 2011 -

June 3, 2011

“While the academics may suggest giving consumers a ’nudge,’ by the time Washington gets finished, this nudge has become a shove, if not a punch in face.”

Read the full story below.

By Carter Dougherty

June 3 (Bloomberg) -- When the U.S. Consumer Financial Protection Bureau officially begins work next month, it will set in motion what will become the largest field test to date of a set of ideas known as behavioral economics.

The Harvard University law professor in charge of setting up the bureau, Elizabeth Warren, used tenets of behavioral economics to propose creating the agency. Michael Barr, a former assistant Treasury secretary, said he was guided by some of its ideas as he helped write provisions of the Dodd-Frank Act’s overhaul of financial regulation. And last month, the bureau hired a Harvard economist steeped in the field, Sendhil Mullainathan, to serve as its head of research.

“The CFPB is almost certainly at the forefront of using behavioral economics for regulation and is the only agency I know of that has a significant player in this field on staff,” David S. Evans, a banking industry consultant and lecturer at the University of Chicago Law School, said in an interview.

The consumer bureau will write and enforce rules for a broad array of credit products, including mortgages, credit cards and payday loans. Lenders are likely to have to alter their products, marketing and business models to comply.

As a result, business groups are beginning to study up on behavioral economics. The Financial Services Roundtable recently invited Mark Calabria, director of financial regulation studies at the Cato Institute, a Washington-based policy research group, to brief lobbyists about how behavioral economics influences the consumer bureau. The roundtable includes major retail financial services players including JPMorgan Chase & Co., Bank of America Corp. and U.S Bancorp.

Rational Decisions

Behavioral economics emerged in the last two decades in reaction to the prevailing assumption that consumers are fundamentally rational, making decisions that maximize their economic interests. Behavioral economics, influenced by psychology, asserts that consumers are often irrational or unable to make the optimal decisions.

Daniel Kahneman, a professor of psychology at Princeton University, won the Nobel Memorial prize in economics in 2002 for his work in the field.

Some behaviorists say patterns of irrational decision- making can be observed empirically, and policies designed to help consumers make more economically rational choices.

Credit Cards

One example of a recent policy based on ideas from behavioral economics was the Credit CARD Act of 2009. Behavioral research suggested that consumers tend to overestimate the savings from credit cards with no annual fees, and underestimate the costs of carrying a balance. In response, Barr said, federal officials revamped credit card statements to require issuers to tell consumers how much it would cost them in fees and interest to carry their balance for a certain length of time.

“That lets the consumer more rapidly adjust behavior to what they want,” Barr said.

One behaviorist is already in a prominent position in the Obama administration: Cass Sunstein, head of the White House Office of Information and Regulatory Affairs. Sunstein, a legal scholar, published a book with University of Chicago economist Richard Thaler in 2008 called “Nudge: Improving Decisions About Health, Wealth and Happiness.”

Critics contend that whatever the value of behavioral insights in economics, it may be unwise to apply its lessons to law, policy and regulation.

‘Nudge’ versus ‘Shove’

“While the academics may suggest giving consumers a ’nudge,’ by the time Washington gets finished, this nudge has become a shove, if not a punch in face,” Calabria, a former staffer for U.S. Senator Richard Shelby of Alabama, the top Republican on the Senate Banking Committee, told the lobbying group on May 11.

Evans argued in testimony before a House Oversight and Government Reform subcommittee last week that Thaler and Sunstein represent “soft paternalism” among academics.

Warren’s writings, he said, show a preference for “hard paternalist interventions.”

Robert Lawless, a University of Illinois law professor and longtime academic collaborator with Warren, said her main interest in behavioral economics stems from its emphasis on collecting data and testing potential solutions.

“I don’t think Elizabeth has preconceived theories, contrary to the way she is often portrayed,” Lawless said in an interview. “She has always liked the data.”

Paternalism

Raj Date, the CFPB’s associate director of research, markets and regulations, said that the long-running debate on paternalism is one reason why legislators limited the new agency’s powers.

“That debate will rage on long after we are all dead,” Date said in an interview. “Congress set out guidelines and constraints as to what the bureau can and cannot do.”

For example, the House rejected a proposal by Barr, a professor of law at the University of Michigan, that would have required financial institutions to offer “plain vanilla” products, such as the 30-year fixed-rate mortgage.

Date, a former executive with Capital One Financial Corp. and Deutsche Bank AG, pointed out that credit card companies routinely run tests before rolling out new products or advertising campaigns. “That kind of test-and-learn discipline can be imported into policy-making,” Date said.

Barr said that other Dodd-Frank provisions also reflect the influence of behavioral economics, particularly Title X, which created the CFPB. “The basic structure of the bureau is designed around having the agency do consumer testing and empirical analysis,” Barr said in an interview.

‘Genius’ Award

Barr, together with Mullainathan and Eldar Shafir, a professor of psychology and public affairs at Princeton University, wrote a 2008 paper called “Behaviorally Informed Financial Services Regulation” that helped guide his work in the Treasury Department.  Mullainathan received a so-called genius fellowship from the John D. and Catherine T. MacArthur Foundation in 2002, and has conducted research on aspects of consumer finance including mortgages, marketing and insurance.

Barr and others wrote provisions in the law directing the bureau to create a new mortgage disclosure form, combining two separate ones that had been developed by the Federal Reserve and the Department of Housing and Urban Development.

Warren has made this requirement her signature issue in setting up the bureau, which recently released model disclosure forms. It has also hired Kleimann Communication Group, a Washington-based research firm, to test the forms with consumers.

‘Poorly Informed’

Warren herself relied heavily on behavioral economics for her 2008 paper, “Making Credit Safer,” in which she and Oren Bar-Gill, the primary author, made the first detailed case for the creation of what became the consumer bureau. “Indirect, behavioral evidence reinforces a vision of poorly informed consumers,” the two wrote.

Date said that the research division Mullainathan will head at CFPB could employ experts from a range of fields including psychology, marketing, sociology, law, and especially economics.

In addition to consumer decision-making, it will have to develop expertise in credit, finance, marketing, and capital markets.

“If you understand those five things, you get it,” Date said. “If you don’t understand all of them, you don’t.”