"MULLAINATHAN: But if you have two dimensions now, you can end with cycling, and cycling has this essential feature that every time someone comes in, it changes the preference ranking, and then the equilibrium is upset, so then some other guy has a different decision to enter, and it turns out one of the things that emerges is that you can get no equilibrium. The features that generate no equilibrium cycling ... which is the notion ... that's what I mean by people want simplicity but can never get it."
"THALER: One footnote on this ... notice if we continue on mortgages as an example, 30 years ago there was essentially one kind of mortgage; 30-year fixed rate. The government passed the Truth in Lending Act that said you have to report interest rates in a uniform way which was APR, and that basically solved all the problems. Choosing the best mortgage, they gave you a sufficient statistic. You look at that number, and you're done. We have zillions of kinds of mortgages. APR is no longer a sufficiency statistic...."
From Edge's "Master Class" Series (A Short Course In Behavioral Economics)
Long story short here; I know that I've abstracted two abstract quotes from this discussion, but they're very important in trying to make sense of the whole market problem, since there seems to be a general trope that two things have happened: Greedy Homebuyers went and bought massively overpriced houses at crazy, unrepayable rates, and Greedy Lenders used fraudulent means to sell people awful, complicated loans. And neither of these answers are accurate - there's no greed there, really. But the fact that we call either side greedy ignores the immediate question of the separation of legitimate self-interest from excessive greed, and the longer term question of what we will ground our empathy (if we find either group empathy-worthy) upon. By which I mean, if empathy is the result of the combination of sympathy and understanding, then how does our understanding of the psychology of economics interact with our general sympathies for those in poverty, and those who aren't necessarily in poverty, but are being forced to give up their expectations and plans for economic reasons.
"MULLAINATHAN: I want to close a loop, which I'm calling "The Irony of Poverty." On the one hand, lack of slack tells us the poor must make higher quality decisions because they don't have slack to help buffer them with things. But even though they have to supply higher quality decisions, they're in a worse position to supply them because they're depleted. That is the ultimate irony of poverty. You're getting cut twice. You are in an environment where the decisions have to be better, but you're in an environment that by the very nature of that makes it harder for you apply better decisions."
To return to those quotes, they're in the context of a discussion about multi-dimensionality in economic problems; in short, how to model the choices of a individual in a system where a given measure changes for an associated variable, instead of remaining constant for all variables. For example, Dr. Mullainathan previous to the quote at hand cites how when you go to Krispy Kreme, you buy four donuts, at which point they offer you an upgrade to a dozen for only 39 cents more. If you model that problem on a demand curve, what happens is that you get the same shape as an old rollercoaster; you get a straight line demand curve (since the price for each donut up 'til four is the same, the per-unit demand is the same) at which point you see a huge drop in demand for donuts purchases between 4 - 11 and a correspondingly massive jump in demand for dozens of donuts. This is not rational. According to classical theory, the consumer goes and buys enough to satisfy rationally determined needs; there should be no actual difference in the per-unit demand curve, since if a person has accepted a per-unit price point for one donut, and they only want four to eleven donuts, it doesn't make sense to purchase more donuts even at a reduced price, because they over-fulfill a given consumer's actual desire. Except that we very well know that when you can maximize your purchase at a greatly increased weight, the opportunity of the value overwhelms the actual utility of the purchase. And so much for classical economics.
This furthermore is the problem behind both the "greedy" homeowners and the "greedy" lenders, since they both faced similar versions of the problem above in pricing their relative purchases. Homeowners simply weren't walking into a lender's office with their minds tuned like Excel spreadsheets; rather, they were being presented with the exact same "Why borrow $200,000 for a house that costs $300,000 at a fixed rate when you can borrow $250,000 at the same initial interest rate, but which switches to a floating Adjustible Rate Mortgage a few years down the line?" that the individual is when they're presented with the "super-sized" K.K. donut dozen. And the economists response is that it's much more intelligent to take the dozen and the larger mortgage, and then save the extra donuts until you want them, and to invest the extra capital in improving the value of the home (re-modeling), buying a pricier home (upgrading), or by using the money for something else of equal or greater personal or professional value (such as vacations, buying stock, paying for school, etc.) If you're not going to do that, says the economist, then the lower mortgage is for you. Which is not something that anyone thinks looking at those numbers.What people think, when they're looking at those numbers, is basically not whether they need the extra money, it turns out, but rather how can they support taking that much more. The reason why I can make that assertion is because of "priming", which is one of the other topics discussed in the Edge series, which basically causes a change in cognition by changing the environment. In this case, the presentation of more options produces a change in valorization; that is, if one only came in and saw two rates, one would choose the lower one - but if one is presented with a higher rate and a lower rate (in an ARM), then one is no longer thinking comparatively but probabilistically, which is a much, much more difficult thing, given over to any number of influences completely unaccountable by current economic measures, in that one, according to the economist, has to take into account is all of the future expectations of earnings, costs, life changes, emergencies, and general feelings about the macroeconomic situation - keep in mind that the valorization of any of these items, as you'll learn if you go through the Edge series, are wildly changed for each and every combination of states that one assumes. Even something like thinking "What if I paint this one room, and get tired of the color in a year?" changes the valorization of the house if you change it to "What if I paint this one room and I get tired of the color in ten months?"
Sound complicated? It very damn well is. Now let's back off, and combine this ugly nest of biting complexity with another observation from psychology - humans are most stressed in situations where they feel they lack control, but are still going to be punished when things go wrong. Overwhelmingly, situations like this lead to all the classical symptoms of anxiety and depression disorders, even in otherwise healthy individuals (in measure of the level of punishment, of course.) Given that one obviously has no control over the world economy, and the housing economy, or even one's job security, individuals are clearly making decisions that are at best only probabilistically rational (something like trying to calculate the odds of risk/return in a casino), rather than the binary "yes/no, good/bad" schema of most individuals when assessing the behavior of strangers.
Hence, empathy. If we're to try and understand what's going on here, it's necessary to take into account that the vast majority of actors here undertook what they did based on acceptably rational reasons that turned out to be wrong because of a peculiar quirk in the human mind which causes value thresholds to be irregular; that is, relative social value. Now, this includes "keeping up with the Joneses", but extends beyond that into understanding how one's given economic position determines access to social goods that aren't included in pure economic exchange. Classic, and most heartbreaking example - good schools. Spots in desireable schools are indirectly related to wealth in that though no one pays individually for public schools, the better ones tend to be middle class-and-up neighborhoods. As such, an individual in buying a house might very well buy a home far beyond their means, that they would lose if/when the rate goes up, on the very reasonable estimation that if they're trying to put a child through a good public high school, and as long as housing values remain at least stable, they can be in-and-out of the house before the rate increase kicks in. The value of the school in driving the individual to accept a ruinous mortgage never shows up in the economists assumptions, nor does it show up in mortgage statistics, which is why it's easy to simply dismiss everyone who took a mortgage as either dumb, greedy, or both, when really every person in this crash could be noble and prudent and it still could have happened.
Empathy then, in this situation, is needed before we apportion blame. It's easy and well-deserved to blame the speculators who packaged these loans; but at each stage, it was a good and prudent thing to do - it made a way for banks to make profit out of sub-prime loans initially, which therefore encouraged them to lend more to lower-income individuals, who therefore were able to achieve "leverage" in an economic sense, which potentially could have served as a means for greater economic security; the economist De Soto's anti-poverty proposal works in a similar manner to this, and he's gotten all sorts of awards for being clever. So calling for the heads of Wall Street traders is pointless; in virtually every case, you'll find that each person was just a normal person doing their normal jobs. What empathy, as an emotion, knows however, is that normalcy is no grounds for not scrutinizing what is going on. Empathy is as much about understanding as it is feeling - which is of course troubling, since individuals who feel that they have no need for others empathy (and there's no one like the successful to feel they need nothing from the unsuccessful) also feels that they do not need the understanding. The quote that most troubles me about this whole affair is the anger A.I.G.'s representatives had towards the S.E.C. and Fed and the rest when they brought to light A.I.G.'s outstanding liabilities; A.I.G. literally believed that just so long as no one knew about the extent of how much was leveraged in the CDOs then there wasn't a problem. It goes to show how the difference between the "magical thinking" that individuals use when estimating value, and the cold hard price-setting, information-providing machine that is the market when described by various Austrians and Friedmanites. As such, as we come to know more, we should always realize that the only ethical course is one in which the vast scope of human motivations is held against the constant realization that all of it must be continually not only scrutinized as much as possible, but always made available for scrutiny to take place in the first place, even if the scrutiny never comes.
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