PHL

different types of fees would be reported, but they would be added up into

a single salient number.

Woodward's research finds that the people who get the best deals-by a

lot! -are those who pay no fee up front. (This just means that the broker

pays all the fees out of his commission. There may be occasional free

lunches, but there is no such thing as a free mortgage.) The likely explana­

tion for this result is that when the fee is zero, it is simpler for borrowers to

compare terms, because the interest rate is the only thing they have to look

at. The interest-rate disclosure would include the rate, of course, but also

a schedule of payments over a period of years, assuming that the underly­

ing interest rates do not change. This would ensure that borrowers at least

know what their payments vv:ill be when the teaser rate ends. It would be a

good idea to add some kind of worst-case scenario information so that

borrowers can see how much their payments could go up in the future.

Lenders would also have to provide a machine-readable detailed RECAP

report, one that incorporates all the fees and interest rate provisions, in­

cluding teaser rates, what the variable-rate changes are linked to, caps on the changes per year, and so forth. This information would allow indepen­

dent third parties to offer much better advice. Our strong hunch is that if

the RECAP data were made available, third-party services would emerge to

compare lenders. Care would need to be taken that the system did not fos­ ter collusion, but we think this would be easy enough to monitor and pre­

vent.

RECAP data would thus make it much easier to shop for mortgages on­

line, which should make the mortgage market more competitive. Online shopping is especially likely to help women and minority groups. A study

of automobile shopping found that women and Mrican-Americans pay

about the same amount as white males when they buy a car online, but at

the dealership they pay more, even after you account for other factors, such as income.4

Student Loans

The cost of going to college has been rising almost as fast as the

cost of health care and rare baseball cards. At many private universities, in­

cluding ours, it costs a student more than fifty thousand dollars a year in

tuition, room, and board. Scholarships and part-time jobs typically do not

cover the cost of college. So students and their families often turn to stu­

dent loans to help out. In fact, loans are a common option. About two­

thirds of four-year college students are in debt when they graduate.

There are two kinds of loans in the marketplace: purely private loans

given by financial institutions, and loans that are backed by the federal gov­

ernment, so-called Stafford loans. These Stafford loans are need-based.

The government pays the interest on the loans while the student is in

school, guarantees payment to the lender if the student defaults, and sub­

sidizes the loans. Lenders find making these loans highly profitable. Unfortunately, student borrowers and their families face the same kinds

of difficulties as subprime borrowers. Similarly misleading mail solicita­

tions come from private lenders, aimed at a younger audience. Some of

these solicitations are hilarious in their absurdity, but apparently they're ef­

fective too. For example, one of the dozens ofloan flyers that our student

intern received in the mail during her senior year of high school suggested

that getting a loan of forty thousand dollars could be as easy as ordering a

pizza, and pictured a pizza chef promising a "Decision delivered within I 5

minutes!" Shopping for a student loan is nearly as complicated as looking for a

mortgage. Students typically try for a federal loan because they are cheaper (a fact not mentioned by the pizza man in the ad), then look at private

loans if necessary. To apply for a federal loan a student must first fill out the

free application for federal student aid ( FAFSA). If the student has also ap­

plied for financial aid at a private college, she must also complete the Col­ lege Board's financial aid profile. Each form contains more than a hundred

questions that vary according to the schools involved, and filling one out

takes many hours. (Some high school and college students joke that it

takes longer than the college application itself.) Like a typical mortgage form, the scale of these questionnaires is over­

whelming. Students are asked to answer questions about their parents'

finances, even if they don't know much about them. After the forms have

been filled out, the Department of Education determines how much the student's family can pay for college (called the expected family contribu­

tion). From there, the college decides on the size of the loan.

Alternatively, the student can go to the private sector for a loan. By

sending proof of college enrollment to the lender, a student can receive as

much money as she thinks is necessary. Unlike federal loans, this money

can be used for any expenses, so direct-to-consumer loans could poten­

tially encourage students to borrow too much and to overspend.

As in the case of mortgages, where a borrower often naively asks advice

from his mortgage broker, students and their parents have traditionally

turned to their colleges' financial aid offices for advice. Of course, most

such offices are helpful and honest. Alas, some of them have been no more

scrupulous than the cricket player turned mortgage broker. The loan offi­

cers offer advice, all right, but instead of a well-intentioned nudge, the ad­ vice has often been a self-serving shove. Some colleges' financial aid offices

have tag-teamed with lenders who had provided gifts, stock options, and

"donations" to the college in order to become "preferred lenders"-a

kind of "Good Housekeeping" stamp for student loans. 5 Occasionally, a

college's financial aid staff tells students that they may choose only lenders

on a "preferred" list, even if these lenders don't necessarily provide loans in

the best interest of the student. At one university, a lender was allowed to

provide staff for a call center under a college's name; when students called in to ask about loans, those "unbiased" employees pushed their own com­

pany's loans. When students took out these loans, the lender kindly shared

profits with the college. One might wonder why lenders are so eager to get the student loan

business that they are willing to engage in practices that are at least sleazy

and possibly illegal. The answer is that the combination ofloan guarantee

and subsidy by the government makes these loans exceptionally profitable,

so lenders compete hard to get the business. Presumably, it was the hope

of such competition that led the government to design the program in this

partially privatized manner, in which the federal government hands out

subsidies but relies on the private sector to distribute the loans. However, the competition has not focused on price. Instead, the lenders have en­ gaged in what economists call rent-seeking activities. The idea is that if

there are high profits to be made, suppliers will be willing to spend a lot of

time and money to get that business. Because excess profits are available to the lenders who snag the student loan business, there are temptations to do whatever it takes to get to the head of the line.

As with mortgages, this example illustrates the problem with directing

people to seek "expert" advice when they face difficult, high-stakes prob­

lems and are confused about what to do. If they don't just reply to the

pizza ad because it is easy, but instead try to get helpful advice, they may

end up with suggestions that are as self-serving as the pizza man's. The ad­

viser they consult has a treasure-confused customers. The opportunity to

fleece confused customers is valuable. There is money on the table. It is difficult to design public policies that inhibit "advisers" from taking that

money. Better to inform the consumer by improving the choice architec­

ture. Ifborrowers could compare loans more easily, then the price compe­

tition that was hoped for might actually emerge.

One helpful nudge would be to simplify the financial aid application.

The complicated format of these forms can discourage students from ap­

plying for financial aid and cause them to seek pricey direct-to-consumer

loans instead. Although the Department of Education has not released a specific formula for how it determines how much aid a family should re­

ceive, an application of RECAP to student loans would start with cutting

down the number of questions on the FAFSA and making them uniform for all loans, federal and private.

The FAFSA application could also be combined with an annual tax re­

turn. In one ongoing Ohio study, tax professionals at H&R Block offer a

FAFSA software package to families likely to qualify for federal or state

financial aid. This software uses the tax return to complete most of the

FAFSA for submission. 6 A RECAP policy would make it much easier for stu­

dents to compare various loan options offered through their school. In­

deed, learning to use a student loan RECAP spreadsheet might be an excel­

lent assignment in a high school math class for seniors.

Another possibility would be to help families avoid loans altogether, or

at least reduce the need for such loans, by helping them start saving for

college earlier via college savings accounts ("529 plans"). In research in

progress by Eric Bettinger, Bridget Long, and Phil Oreopoulos, eighth graders and their parents must meet with school counselors and receive a

small nudge. At the meetings, families are offered the option of directly

depositing money from a checking account into a college savings account each month. As an incentive, they receive one hundred dollars in savings for signing up. Through this process, families could conveniently save

money for college. 7

Credit Cards

The credit card is a ubiquitous feature of modern life. It is nearly

impossible to function in society without one. Try checking into a hotel,

renting a car, or renting a set of golf clubs without a credit card. Good

luck. Credit cards serve two functions. First, they provide a mode of pay­

ment in lieu of cash, and have largely replaced checks for that purpose in

face-to-face transactions-thankfully-although occasionally you still get

stuck behind someone in a grocery store checkout line who wants to write

a check for a $7 ·37 purchase. The second purpose of a credit card is to pro­ vide a ready source of liquidity if you want to spend more than you cur­

rently have in cash. Debit cards, which look just like credit cards, serve

only the first function, because they are linked to a bank account and do

not allow for borrowing unless linked also to a line of credit. (Warning:

some debit cards offer lines of credit at high fees. If you use a debit card to

borrow, you should make sure that the fees you pay are lower than they

would be with a credit card.)

Credit cards are blessedly convenient. Paying with a credit card is often

faster than paying with cash, and lets you avoid struggling with change;

digging into your pocket to find the correct change and managing the

large jar of pennies at home are vexations from which you are liberated.

Not to mention the frequent flyer miles! But if you are not careful, credit

cards can be addicting. Consider these numbers:

• The Census Bureau reported that there were more than I.4 billion

credit cards in 2004- for 164- million cardholders-an average of 8.5 cards per cardholder.

• Currently, IIS million Americans carry a month-to-month credit card

debt.

• In 1989 the average American family owed its credit card companies $2,697; by 2007 that number had grown to about $8,ooo. And these

figures are probably too low because they are generally self-reported.

Using Federal Reserve data, some researchers suggest that American

households may have an average credit card debt of$u,ooo. At typi­ cal interest rates of 18 percent per year, that translates into more than

$2,ooo a year in interest payments alone.8

CREDIT MARKETS 143

Looking back at the problems of self-control discussed in Chapter 3, we

can see how credit cards create serious problems for some people. In the

pre-credit card era, households were pretty much forced to use a pay-as­

you-go accounting system. That is why people used jars of money labeled

according to purpose or payee. Now if you don't have the cash to fill your car up with gas, there is always your credit card. Credit cards inhibit self­

control in other ways. One study by Drazen Prelec and Duncan Simister

( 2001) found that people were willing to pay twice as much to bid on tick­

ets to a Boston Celtics basketball game if they could pay with their credit card rather than cash. There is no telling how much money people pay

with the cards in order to get those precious frequent flyer miles. And

when the spending limit on one card is reached, there is always another

card to use, or a new account can be opened using one of the solicitations

that arrive almost daily in the mail announcing that you have been "pre­

approved." Can libertarian paternalism help? As with mortgages, we think this is a

perfect area for RECAP. We suggest that credit card companies should be required to send an annual statement, both hard copy and electronic, that

lists and totals all the fees that have been incurred over the course of the

year. This report would serve two purposes. First, credit card users could

use the electronic version of the report to shop for better deals. By know­ ing their precise usage and fee payments, customers would get a better

sense of what they are paying for. Here is one example. One way credit card companies have slyly raised

prices is by reducing the number of days you have between the time you get your bill and the day your payment is due. If you miss that payment

you not only pay a penalty, but you also pay interest on all the purchases

you make next month, even if you normally pay off your bill in full. For a

heavy credit card user, such as a frequent business traveler, missing a five thousand -dollar payment by one day can result in an extra payment of

more than one hundred dollars.

Second, the report would~make more salient to users just how much

they are paying over the course of the year. Some credit cards now issue an annual summary of purchases, listed by category, which can help for tax

preparation, but the RECAP requirement would force the card issuers to in-

dude information on their own fees in this document. Often those fees are

hidden. For example, if you make a purchase in a foreign currency, the

credit card company tacks on a fee for converting the purchase into dollars

(something that costs banks virtually nothing). On your RECAP statement

you would be told how much you paid for the privilege of using your card

on your vacation to Mexico. Because interest on credit cards is not de­

ductible, there is no particular reason for users to check how much they

paid in interest last year on all their credit cards, and fees are likely to be

buried and ignored altogether. Imagine the wakeup call for a credit card

user who is told that over the past year he paid $2,I53 in interest, $247 in

late fees, and $57 in currency transaction fees.

Some other nudges could help as well. For example, credit cards always

mention the minimum payment you can make when you receive your

monthly bill. This can serve as an anchor, and as a nudge that this mini­

mum payment is an appropriate amount.* Of course, because the mini­

mum payments are tiny relative to the total bill, paying this amount just

maximizes the interest payments over time. Credit card companies even

make it hard to commit yourself to paying the card off in full each month.

Try to set up an automatic payment feature with your credit card and your

bank. Chances are the only default option offered is to pay the minimum

payment, not the entire bill. We think that companies should be required

to allow automatic payment of the full bill.

We have covered a number of topics in this chapter, but the unifYing

message is simple. For mortgages, school loans, and credit cards, life is far

more complicated than it needs to be, and people can be exploited. Often

it's best to ask people to take care of themselves, but when people borrow,

standard human frailties can lead to serious hardship and even disaster.

Here as elsewhere, government should respect freedom of choice; but with a few improvements in choice architecture, people would be far less

likely to choose badly.

*Similarly, credit card limits, which are nominally in place to limit spending, may serve as high anchors that actually encourage spending.

9 PRIVATIZING SOCIAL SECURITY:

SMORGASBORD STYLE

In the 2ooo U.S. presidential campaign, George vV. Bush called

for a partial privatization of the Social Security system. According to his

plan, a portion of the payroll tax would be designated for individual sav­

ings accounts. At the same time that this issue was being debated in the

United States, Sweden was launching a system similar to President Bush's proposal. Although Bush's plan did not get much attention in the early

years of his administration, it resurfaced prominently in 2005. Though it

failed in Congress, some version of this proposal is likely to be considered

again before long, either in the United States or in other countries. Im­

portant lessons can be learned from the Swedish experience-lessons,

above all, about the limitations of any simple celebration of freedom of

choice. We shall see that Sweden's officials did quite well on some aspects of

their choice architecture but made at least one important error that led its

citizens to choose portfolios that are not nearly as good as they could have

been. A better set of nudges would have helped. By understanding why, we can learn a lot about Social Security reform, and about much else besides.

Design of the Swedish Privatization Plan

If we were to pick a single phrase to characterize the design of the

Swedish plan, it would be "pro-choice." In fact, the plan is a good exam­

ple of the Just Maximize Choices strategy. Give people as many options as

145

252

18 THE REAL THIRD WAY

In tl1is book we have made two major claims. The first is that seem­

ingly small features of social situations can have massive effects on people's

behavior; nudges are everywhere, even if we do not see them. Choice archi­

tecture, both good and bad, is pervasive and unavoidable, and it greatly af­ fects our decisions. The second claim is that libertarian paternalism is not an oxymoron. Choice architects can preserve freedom of choice while also

nudging people in directions that will improve their lives.

We have covered a great deal of territory, including savings, Social Secu­

rity, credit markets, environmental policy, healtl1 care, marriage, and much

more. But the range of potential applications is much broader than the top­

ics we have managed to include. One of our main hopes is that an under­

standing of choice architecture, and the power of nudges, will lead others to

think of creative ways to improve human lives in other domains. Many of those domains involve purely private action. Workplaces, corporate boards,

universities, religious organizations, dubs, and even families might be able

to use, and to benefit from, small exercises in libertarian paternalism. With respect to government, we hope that the general approach might

serve as a viable middle ground in our unnecessarily polarized society. The

twentieth century was pervaded by a great deal of artificial talk about the

possibility of a "Third Way." We are hopeful that libertarian paternalism offers a real Third Way-one that can break through some of the least tractable debates in contemporary democracies.

Ever since Franldin Delano Roosevelt's New Deal, the Democratic

Party has shown a great deal of enthusiasm for rigid national requirements

and for command-and-control regulation. Having identified serious prob­

lems in the private market, Democrats have often insisted on firm man­

dates, typically eliminating or at least reducing freedom of choice. Repub­ licans have responded that such mandates are often uninformed or

counterproductive-and that in light of the sheer diversity of Americans,

one size cannot possibly fit all. Much of the time, they have argued on be­

half oflaissez-faire and against government intervention. At least with re­

spect to the economy, freedom of choice has been their defining principle.

To countless ordinary people, the resulting debates seem increasingly tired, abstract, and unhelpful-pointless sloganeering. Many sensible Dem­

ocrats are fully aware that mandates can be ineffective and even counter­

productive, and that one size may not fit all. American society is simply too

diverse, individuals are simply too creative, circumstances change too

rapidly, and government is simply too fallible. Many sensible Republicans

know that even with free markets, government intervention cannot be

avoided. Free markets depend on government, which must protect private

property and ensure that contracts are enforced. In domains ranging from

environmental protection to planning for retirement to assisting the

needy, markets should certainly be enlisted. In fact, some of the best

nudges use markets; good choice architecture includes close attention to incentives. But there is all the difference in the world between senseless op­

position to all "government intervention" as such and the sensible claim

that when governments intervene, they should usually do so in a way that promotes freedom of choice.

For all their differences, liberals and conservatives are beginning to rec­

ognize these fundamental points. No less than those in the private sector,

public officials can nudge people in directions that will make their lives

go better while also insisting that the ultimate choice is for individuals, not for the state. The sheer complexity of modern life, and the astounding

pace of technological and global change, undermine arguments for rigid

mandates or for dogmatic laissez-faire. Emerging developments should

strengthen, at once, the principled commitment to freedom of choice and the case for the gentle nudge.