Decision making without boundaries – should we cherish it?
AUTHOR: GÉ CUIJPERS
JUNE 5, 2018
People make dozens of decisions in their every day life. Some of small, and others of large importance. Although, we have to make many decisions during our life it remains difficult to make the right choice on the right moment. Besides, not all decisions made by people are well understood by others. Often the Homo Economicus’ assumption of rational decision making is violated. It’s not without reason that the field of Behavioural Economics has been gaining importance over the last couple of years. An interesting question arises, if people indeed make irrational decisions, should we then really cherish free decision making, or is it better to (e.g.) use “nudging” or forbid certain decisions?
The most important decisions over ones’ life-cycle are often accompanied with monetary effects, they are financial decisions with far-reaching consequences. Lots of examples exist, which show that free decision making by people can lead to disastrous future outcomes as a result of choosing the wrong option. I will elaborate on some of them.
In Italy they face a bail-in headache. Compared to other countries in Europe households are relatively more exposed to bank debt. The Italian banks raise subordinated and hybrid debt, which under the Basel Accord rules is allowed to account for a part of the mandatory capital ratios, via their retail branches. Households, often unaware of the risks, buy these debt products massively. Research has shown that in 2015, 40% of the total bond assets held by households was bank debt. Other investigations, into financial literacy have put forward an alarmingly low level of financial knowledge. At this very point, the problem comes to the surface. People assuming that they have invested their well deserved money in safe assets, end up disappointed when their bank gets into trouble and their money is used as part of the bail-in mechanism. Evidence from Italy demonstrates that in many instances there has been deviated from a full-fledged bail-in, because households were too heavily exposed. Little knowledge about financial risks and corresponding interest rates is to be blamed.
Another example is the the affair surrounding interest rate swaps. In the Netherlands banks sold interest rate swaps to small and medium-sized enterprises (SMEs). They had to pay a fixed interest rate and they received a variable interest rate. However, these swap positions were entered before the financial crisis in an environment of increasing interest rates. When interest rates started to drop as a response to the outbreak of the crisis, SMEs came in financial difficulties.
The last example is about the interest-only mortgages, which used to be very popular in the Netherlands for its high tax rebate on mortgage interest payments. The last couple of months have proven that a large bunch of people, who own such a mortgage, are not aware of and unable to pay the full mortgage amount at maturity.
What I tried, and hopefully succeeded in, to show with these examples is that decision making is rarely easy and never without consequences. Multiple causes can be blamed for these issues. First, decision-makers themselves. It might be a bit naïve to think that you get a high interest rate for a safe investment. A bank is no charity organisation, so they will never give their customers “free money” because they like them so much. SMEs could have been aware of the fact that gaining in a swap contract has a reverse in a different state of the economy, why would a bank enter into a swap otherwise? A swap contract has winners and losers, which unfortunately might be SMEs. And customers buying an interest-only mortgage should know, by using their common knowledge, that a loan is a loan. On some moment in time you have to repay it, otherwise it wouldn’t listen to the name “loan”. But, on the reverse people themselves are not the only ones having a stake in the problem. The reverse side is that the counterparty, with financial decisions mostly banks, lack in transparency. They fail to inform, irrational low-informed individuals, correctly. Therefore, they have to reimburse large amounts of money to the SMEs, who entered an interest swap with them.
Fortunately, possible solutions exist. Starting with an improvement of the own knowledge and external information provisioning about products. Another player is the government; they have the ability to infringe on free decision making. Sometimes it is better to just forbid certain products or choices, like they did with the interest-only mortgage. They as well have the ability to oblige by law banks or other financial institutions to provide sufficient and clear information about products. Lately, a new way of influencing decision making has been originated by 2017’s Nobel Prize winner Richard Thaler. He introduced the term “nudging”, which has the ability to push people towards the rational option when making a decision.
We have seen some examples of financial decision making. These are part of a larger pile of important decisions people have to make over their life-cycle. Obviously, people have great difficulty in making the right financial decisions, with disastrous outcomes as a result. This paves the way for solutions like self-informing, improved information provision, government interaction, and nudging. It remains to be seen, whether people approve limitations in free decision making to improve their own future well-being.