III. CONSUMER CREDIT
The consumer credit market has received renewed attention in the wake of the recent financial crisis, itself precipitated by a wave of defaults on residential mortgage loans. In response, the Dodd-Frank Act (164) created a new agency charged with regulating consumer loans, the Consumer Financial Protection Bureau, (165) which is expected to lead to regulatory change. Moreover, the last decade has witnessed a burgeoning behavioral literature on consumer credit that provides a new intellectual foundation for some form of government intervention. Scholarly work has documented ways that bounded rationality and bounded willpower result in socially costly consumer credit market mistakes. Mortgage loans to consumers who were in no position to pay them off is the most visible example. Those mistakes are then amplified by the strategic behavior of firms, which have powerful incentives to design contracts to exploit these behavioral irrationalities.
The dominant approach in BLE to consumer credit regulation limits itself, yet again, to choice-preserving interventions. The principal policy tool suggested is mandatory disclosure that will, it is argued, enable correction of consumers' systematic mistakes. A second tool is a form of default rule referred to as a "sticky default"; while not mandating use of any particular contractual form, these defaults are designed to make it costly to opt out of a "plain vanilla," easy-to-understand form. As with retirement savings, interventions that would explicitly limit choice are excluded from detailed or sustained analysis from the very start.
Our story here is much the same: the BLE approach fails to take its own behavioral insights seriously enough. BLE inappropriately truncates its policy analysis by excluding policy tools that might be optimal from a social-welfare perspective but that could not be sold as "preserving choice." Mandating new forms of disclosure is unlikely to significantly improve outcomes when (1) the underlying contractual complexity would remain and (2) firms have strong incentives to undermine choice in response to the required disclosures. In addition, the sticky default rule approach is once again, in effect, largely a way to wrap a mandate in a choice-preserving facade. Reliance on the illusion of choice avoids grappling with the difficult tradeoffs that confronting such mandates directly would pose.
A complete behavioral approach would more comprehensively explore alternative regulatory tools, such as product regulation or ways to lower firms' incentives to exploit consumer mistakes, that are perhaps better designed to account for consumer behavioral irrationalities. It would also compare the costs and benefits of disclosure mandates and default rules to those of a full range of regulatory options.
A. The Neoclassical Account of the Policy Problem
In the neoclassical account, consumer credit markets allow households to move income from the future into the present, which enables households to finance purchases of expensive consumer durables like cars and homes, to make investments in education, and to smooth their consumption despite changes in their income over their lifetimes. Consumers are assumed to be able to analyze competing credit offers and choose the product and level of borrowing that maximizes their well-being.
In this account, the primary market failures here are due to asymmetric information and imperfect competition. Asymmetric information stems from consumers having better information than lenders about their own ability to repay and about the actions they take that affect their ability to repay. This market failure entails the borrower using this information advantage to exploit the lender and thus does not justify consumer protection regulation. Rather, it explains private arrangements and associated legal institutions that protect lenders, most importantly collateral and security interests. …