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Guiding People Out of Financial Self-Destruction

A fascinating new book shows a whole new aspect ofbehavioural economics

A recently released book named 'Scarcity: Why Having Too Little Means So Much'', written jointly by an economist and a psychologist, has given an interesting twist to behavioural economics. The book focusses on the connection between poverty and behaviour, but in an entirely new way. It is always assumed that certain kinds of financial behaviour cause poverty. However, 'Scarcity' shows--experimentally, as well as by constructing a plausible explanation--that the causality flows the other way too. Poverty causes self-destructive financial behaviour, thus creating a vicious circle. It doesn't stop there. The nature of the behaviours is such that a large scale fix is possible.

The basic idea is that there is a distinct psychology of scarcity that forces people to think differently. When they know money is short, it occupies more and more of their mental capacity. This actually reduces their ability to think clearly about the same problems, to do what they even know is the right choice. In old-fashioned terms, it whittles down their willpower.

This is not something that is inherently a part of poverty. A similar effect also occurs regarding the scarcity of time--people who are short of time get stressed and take decisions that waste time. It's also not inherent to poverty. A rich person who desperately needs a million dollars acts under the same psychology of scarcity that a poor one needing a small amount does.

There's a lot more in the book but what I find interesting is its implications for the kind of financial savings and investment instruments that are available. The implications are not easy to swallow for anyone who believes in what they might call market-led innovation in financial products. It appears to imply that people can't make the right choice and so, someone else must make the choices for them. That'll sound unpalatable but as its clear from what authors Mullainathan and Shafir discuss, it doesn't actually mean a command and control financial sector.

Here's a recent Indian example of what I mean. The Reserve Bank has said that banks should inform credit card customers on their statements that paying only the minimum balance would result in not being able to clear the debt for a long time and result in a very high interest payout. We all know that high credit card debt and this minimum payment cycle is a widespread problem, especially with younger and lower income customers.

There are possibly three things that the Reserve Bank can do about it. One, it can ask bank to warn customers in vague, non-specific terms, as it has chosen to do. Two, it can force banks to give a statement like 'If you pay only the minimum balance every month, then even without additional expenses, it will take you X years to pay off the entire amount, which will add up to Y during the period. The total interest outgo will be Z'. Obviously X, Y and Z will be real figures calculated for each customer. The third alternative is to force banks to set the minimum monthly payment at such a level that the entire debt gets paid off in a reasonable period, say twelve months. After all, credit cards are not meant to be long-term debt.

Out of these three types of responses, the RBI goes for the first one which is basically a cover-my-back meaningless gesture, no more than pretending to solve the problem. It is also, (i suspect not just incidentally) the one that means the most profits for the banks. The second alternative and the stronger third one would be the ones that Messrs Mullainathan and Shafir would see as a solution that gently guides the financially stressed to less self-destructive behaviour. However, for this regulators have to start thinking their way out of the boxesthat they are locked in.