A conversation with the author and behavioral finance theorist.
Question: What is a “nudge”?
Richard Thaler: Let me give you an illustration of a nudge. It’s funny, it’s one paragraph in our book, but it’s by far the most famous example from the book. It turns out some genius who, an economist in fact, allegedly at least, an economist who works for the Amsterdam International Airport Schipol, got the brilliant idea to etch the image of a housefly in the urinals in the men’s bathrooms at the airport. This image of a housefly, it looks extremely realistic. You can see a picture of it on our website nudges.org. It’s located just near the drain. It turns out, that men, when they’re taking care of their business, they’re not fully attending to the task at hand, but, I’m sure there’s an evolutionary explanation for this, if you give them a target, they will aim. According to the people who run the airport, spillage has been reduced by 80%. That housefly has become my favorite illustration of a nudge.
So, what’s a nudge? A nudge is some small feature of the environment that attracts our attention and alters our behavior.
Question: What is the difference between a nudge and a push?
Richard Thaler: It comes down to values. When should we nudge and when should we shove, I think, it’s a political judgment. Obviously in some situations we need shoves, we need laws. Fraud is against the law, murder is against the law, drunk-driving is against the law. We don’t need just nudges.
On the other hand, sometimes we can combine the two. So for example, in some states if you’ve been convicted of DWI, Driving While Intoxicated, after you serve your sentence and you get your license back, you also have to equip your car with some device that requires you to pass some sobriety test before you turn the car on. I think that’s probably a good rule. So we can push the two but. Where we’re going to go on various public policy issues will be a political decision, where of course, people will differ.
Question: How can we identify and allocate risk better?
Richard Thaler: I think the people who’ve been the most overconfident in our business in the last decade have been the people that called themselves risk managers. And the reason is they failed to learned the primary lesson we should have learned from when Long Term Capital Management went belly up ten years ago. That is, investments that seem uncorrelated can be correlated simply because we’re interested in it.
LTCM lost money when Russia defaulted on a certain class of bonds, and then they had other investments like on the spread between two different kinds of shares of Royal Dutch Shell Oil Company. Now that seems completely unrelated to Russian bonds. But they were related because other hedge funds saw similar discrepancies and they were all making similar bets.
So the world is much more correlated than we give credit to. And so we see more of what Nassim Taleb calls “black swan events”-- rare events happen more often than they should because the world is more correlated.
I think one lesson we have to learn is that there’s a lot more risk than we’re giving credit to, a lot more what economist calls systematic risk.
I think we also have learned the lesson that we have to have better incentive structures.
Question: How can firms incentivize prudent financial transactions?
Richard Thaler: One simple step firms can take is make sure that people that are getting paid a lot of money, say more than a million or two, that a big chunk of that money is deferred. That’s going to change the whole ballgame. The money has to be deferred with what they call “clawback,” which means they can get it back if I lose it all. So that guy making ten million a year selling credit default swaps, if we’re going to keep five million of it in escrow for ten years, and with the right to go back and get it, if he starts losing money, then we’re going to give people the right incentives not too take so much risk.
The same with the mortgage brokers that were selling people mortgages they couldn’t afford. We shouldn’t pay them on each mortgage they write. They should have what they call “skin in the game,” where they’ve got to reimburse us if the guy who sold the mortgage defaults.
I think that there are lessons that the financial services industry can learn and, as I said, they should either aggressively take these steps on their own or expect Congress to act.
Question: How can people be encouraged to save money?
Richard Thaler: Everyone’s lost a lot of money on their 401k plans. I’ve heard some people calling them 201k plans. So it’s even more important to get people to be saving more for retirement. Behavioral economics has helped us learn a lot about how to do that.
One simple way is what’s called automatic enrollment. Now this is just changing what are called the default options.
In a typical 401k plan, when you first become eligible you get a big pile of forms and you’re told, fill out these forms if you want to join. Tell us how much amount you’ve saved and how you want to invest the money. In, under automatic enrollment you get that same pile of forms but the top page says, if you don’t fill out these forms, we’re going to enroll you anyway and we’re going to enroll you at this saving rate and in these investments. If you don’t want to join, then sign here that says I don’t want to join. That increases the number of people who joined, and the speed at which they joined, by a huge amount.
There’s a second component of a good savings plan, which is something that a colleague of mine called Schlomo Benartzi and I developed many years ago, that we call “save more tomorrow.”
“Save more tomorrow” is a nudge to help people do what they know they want to do, which is save more, but they can’t bring themselves to save more now. Just like many of us are planning to go on diets next month, or maybe in two months, certainly not tonight.
So, here’s how “save more tomorrow” works. A company invites their employees to sign up for a plan where every time they get a raise, some part of that raise goes to increasing their contribution rate to the 401k plan. In the first company we convinced to adopt this plan, saving rates tripled.
No one was forced to do it, right? So, this was a nudge.
Question: How can the US government nudge companies to nudge employees to save money?
Richard Thaler: In 2006, Congress adopted the following law, it’s called the Pentium Protection Act. It’s actually a 900 page bill, but there’s two paragraphs that are nudges. What it says is, that if a company has those two features, automatic enrollment and a primitive kind of “save more tomorrow”, they have to enroll people at least a 3% saving rate and they have to automatically escalate that at least 1% a year, for at least three years, and if they do those two things, and they have a match, so the company contributes something to the plan as well, so they have those three things, then they get a free pass on some compliance form that companies find very onerous, that shows that not too much of the benefits are going to the highest paid workers. They get that free pass because if they’ve adopted those things, then it’s almost certainly the case that they’re in compliance.
I think this is a perfect illustration of nudging, of light handed regulation, it’s not telling companies you must have automatic enrollment, you must have “save more tomorrow,” you must have a match. It’s telling them if you want to do that, then here’s a little carrot, you won’t have to fill that form out. I think that’s a great model for how government can use nudges in regulation.
Topic: “Well-intentioned” capitalism.
Richard Thaler: I think there’s an opportunity here for new kinds of businesses who can sell trust and it’s tricky.
Let’s take the credit card market. Credit cards have been extremely profitable to banks. They’re profitable not from the fees they collect from the retailers that use the credit cards, that pays the bills, but the real profits come from the interest payments and the charges to users that are unexpected.
So I miss my payment by a day. They hit me with a $50 penalty. They increase my interest rate by 5%.
Is there a market for somebody selling a credit card that helps people pay down their balances? I think the question is yes. But it would have to be sold by a bank that’s really willing to invest in being a trusted partner with its consumers, because they will make less money on each consumer. If rather than setting the minimum balance as the lowest possible amount, so we keep people in debt for as long as possible, we raise the minimum payment and encourage people to pay off their credit cards, we’re going to make less money, but we’re going to have costumers that are more solvent.
Here’s a very practical example in the credit card business. One thing credit card companies often do is. They’ll tell you, you have a $2000 credit limit, now you might think that means that if I go over that, the card will be rejected. No that isn’t what it means. The card companies will often, as a courtesy, honor that credit card, but hit you with a penalty. And you keep swiping your card for $3 at Starbucks for your latté, and you’re getting hit with a $25 penalty because it’s over your credit limit.
It would be much more consumer friendly for them to beep you when you swipe your card that says, uh-oh you’re over your limit, are you sure you want to use that? Maybe you’ll take the cash out. So a credit card company or a bank that goes into the business of saying we’re going to be the broker, we’re going to sell you a mortgage that you’re going to be able to pay off, we’re going to help you reduce your credit card debt, we’re going to help you save for retirement, we’re going to put you into mutual funds that have low fees rather than high fees. I think there’s an opportunity for such a bank.
Topic: A practical example of “well-intentioned” capitalism.
Richard Thaler: Suppose I’m a wine lover, suppose that’s my vice, that I can’t walk past a wine shop without walking in and browsing and the next thing I know, there’s some expensive bottle I’m walking out with.
Well I might be interested in a credit card that I tell them, don’t honor this credit card in wine shops. Or I’m not allowed to spend more than $500 a month on wine. If I go over that, stop me. Why should a bank offer that credit card, right? They’re making less money, unless I realize, gee that’s great that they’re offering me that card it’s really helping me out, so when I need a mortgage, I’m going to go to them. When I need IRA, I’m going to go to them, maybe when I get older and I’m thinking about buying an annuity, I’ll go to them.
But it’s only going to work if they really are your trusted friend.
Recorded on: June 19, 2009.