If most people made rational decisions to maximize their self-interest, as predicted by traditional economists, then everyone would have an emergency fund, accumulate adequate retirement savings, avoid payday loans, and be financially secure. The reality, as demonstrated by the growing research in behavioral economics, is that we often make emotional, short-sighted, and self-defeating financial decisions.

We are easily confused by having too many choices and too many pages of fine print. We are motivated by unconscious cognitive biases.  Unscrupulous financial services providers play to our human weaknesses with products that trap consumers in a cycle of debt.

 

Similarly, if the financial world could be trusted to act in its own long-term self-interest through self-regulation, then former Federal Reserve Chairman Alan Greenspan wouldn’t be eating crow and we wouldn’t be in a global financial crisis. (Greenspan recently told Congress he was “shocked” that markets did not operate according to his ideology.)

 

The good news is that we are beginning to understand how consumers behave in the real world and, with this knowledge, we can craft public policies and financial products that acknowledge our human weaknesses and the danger of placing too much faith in the free market, while continuing to foster economic growth and innovation. For example, by developing “automatic” retirement savings plans and products, where employees are entered into retirement plans by default instead of opting in, we can increase savings and deposits that can be used to promote lending and investments while decreasing the risk of poverty among older Americans.

 

President Obama’s proposed Consumer Financial Protection Agency is an important first step towards incorporating what we know about human decision-making into sound financial policy. Instead of sweeping our frailties under the carpet of theory, the CFPA acknowledges them and proposes ways to help us make better decisions for ourselves, our families, and our communities. Right now, the CFPA is facing fierce opposition from the financial sector, which profits off our cognitive quirks. Please tell your legislator that long-term financial stability is more important than short-term profits.

 

For more on behavioral economics and how it applies to public policy, I highly recommend Dan Ariely’s article The End of Rational Economics in Harvard Business Review (July-August 2009) and his book, Predictably Irrational: The Hidden Forces That Shape Our Decisions (Harper Collins, 2008). Ariely is the James B. Duke Professor of Behavioral Economics at Duke University in Durham, North Carolina. I also recommend the book Nudge: Improving Decisions about Health, Wealth and Happiness, by Cass Sunstein and Richard Thaler (Yale, 2008).