Financial Policy and DecisionMaking in Low Income
Households
Sendhil Mullainathan
Eldar Shafir
Two Dominant Views of Poverty
Rational Choice view
– Consistency, Willpower, Well-defined preferences,..
– Behavior: calculated adaptation to prevailing circumstances
Pathology view
– Psychological pathologies specific to the poor
– Impatient, no planning, confused
– Behaviors endemic to “culture of poverty”
An alternative:
Neither rational nor pathological; just plain human…
A Psychological Perspective
• Large body of decision research (among the
“comfortable”):
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Biases in decision making
Limited willpower
Malleable preferences
Channel factors
• Operating assumption:
– Rich and poor have similar psychological make-ups
– Expression is different in different contexts
– Consequences can be different
Psychology: Power of Context
• Darley and Batson
• Recruited seminary students to deliver
practice sermon on the parable of Good
Samaritan
• After completing surveys, told to go to
another building for the sermon
• Half (“Rushed”) were led to believe they
were running late
Psychology: Power of Context
• On the way to give talk, all participants
passed an ostensibly injured man slumped
in a doorway, coughing and groaning.
• Key DV: Would individual stop?
Psychology: Power of Context
• Outcome:
– No hurry 63% helped,
– Medium hurry 45%
– High hurry 10%
• Notice:
– These are priests…ironically giving a lecture
on the good samaritan
• Key insight:
– Channel factors. Facilitate good behaviors
The failure to act…
(Lack of attention; indecision; decision avoidance; procrastination;
status quo..)
Elective surgery:
10% of older adults who were willing to consider total joint
arthroplasty, and were perfect candidates, chose to have it.
Interviews with others: Hadn’t decided “no”; just deferred…
(Hudak et al.)
Medical self-exams:
Among teaching physicians!..:
“… low rates of self-examination for both TSE and BSE.
Barriers… included embarrassment, perceived unpleasantness and difficulty, concern about reliability, and
worries about what tests might reveal...”
“Where standard intuition would hold the primary cause of
a problem to be human frailty, or the particular weakness
of a group of individuals, the social psychologist would
often look to situational barriers and to ways to overcome
them.”
Ross and Nisbett, 1991
Theme Common to Both Traditional Views:
Major problem => Major Cause => Major intervention
Large subsidies
Costly education
A change in values and “culture”
Instead: Social psych / BDT may provide different insights,
which can be used to explain (and intervene with) behavior of
the poor…
minor situational details can have a large impact
context, construal, etc.
Channel Factors (Lewin)
• Contrary to major interventions that prove
ineffectual, apparently minor situational details
can have a large impact…
• Leventhal, Singer and Jones:
– Students receive persuasive messages about tetanus
inoculation. Offered tetanus shot
– Only 3% showed up later at shot
– If given map and urged to decide particular time, 28%
showed up.
• Did students “want” tetanus shot? Revealed
preference
Two implications of this insight
• Revealed preference:
– Outcomes do not reflect “deep” preferences
• Design of institutions
Poor versus Rich
• Why might common failings such as these lead
the poor to be more affected than the rich?
– Different institutions
– Different problems/circumstances
• Will use this perspective to understand three
phenomena about financial services:
– Banking services
– Payday borrowing
Role of Institutions
• Shape defaults
• Provide implicit planning
Defaults
Institutions Shape default
• Power of direct deposit
– Default translates from cash in hand to cash
in account
– Must take active step to withdraw certain
amount of money
• Gives simple perspective on how direct
deposit could have very large
consequences for behavior
• Suggests simple policy intervention
Institutions Provide Implicit
Planning
• Problem of planning:
– Attention
• How much time have you spent deciding how
much to save for retirement?
– Time inconsistency
• Hard to stick to plans
• Hard to continue implementing plans
Problem of Planning
• Intentions don’t always match behavior. Examples from
US data
• Consumers report a preference for flat or rising
consumption paths
– But consumption drops by 1/3 after midlife
• 76% of households believe they should be saving more
for retirement
– Baby boomers report desired savings rate of 15%. Actual
savings: 5%
• One quarter of employees say they’ll increase 401(k)
savings in the next quarter.
– Only 3% do.
Institutions Provide Planning
• Even credit card companies send
reminders
– Solve attention problems
• Automatic bill payment
– Solve attention problem in the best way
• 401(k)
– Make savings automatic. Best planning
possible
Lack of Planning Institutions
• Poor risk late fees, missed payments
disconnected utilities, etc.
• Key policy insight:
– How do we facilitate more automatic planning
amongst poor?
Contexts
• So far, have talked about institutions
• Now we discuss three non-institutional
context differences
Lack of Financial Slack
• Financial slack
– Different from economic model
– Assumes there is always “frivolous”
consumption
• Consumption that is not really valued by future or
past selves
• Lots of slack means
– Easy to deal with planning mistakes
Rich and Financial Slack
• Suppose a rich individual makes a mistake
and forgets about his credit card bill which
then comes due
• Can cut back on expenses to pay it
– Eating out less
– An IPod purchase
Poor and Financial Slack
• Suppose a poor individual makes a
mistake and forgets about his credit card
bill which then comes due
• Can cut back on expenses to pay it
– Eating!
– Rent payment
• In other words, if the poor are at the
margin of fewer frivolous expenses they
are more exposed
Poor face difficulty in cutting back
• Cost of cutting back high
– Late fees are high
• 5% late fee for a monthly bill is equivalent to 100% APR
• Bigger problems
– Loss of home
– Loss of telephone
• Reconnect fees
– Loss of car
• Late to job - > Loss of job
– Each of which has consequences
Poor on the edge
• Suggests that mis-planning can lead to
two phenomena:
– Large desire for credit funds even at very high
rates
• Extremely important point we return to later
– Falling over the edge
• Domino effect of phones being cut off, etc.
Difficulty of Small to Big
Transformation
• Many of the purchases needed by the
poor are big
– Durables
• Yet much of their income is small
• Produces central tension:
– How to transform small amounts of cash into
big amounts?
– Key role of savings and other institutions
Difficulty of Savings
• “Voluntary” mechanism
– Raises problem of Self-control
• Alternative mechanisms
– Lotteries
• Relation to ROSCAs
– Layaways
• Notice inflexibility
• Suggests class of savings mechanisms should
focus specifically on this problem
– Very different from buffer stock
No buffer stock
• Another key feature of lives of the poor:
– Extremely high volatility of incomes
• Yet key puzzle: Why the lack of a buffer stock
– Again, self control problem: leaky bucket
– Note: due to lack of financial slack, poor would need a
bigger buffer stock.
• Design challenge:
– Create buffer stock institution that cannot be tapped
into for temptations
Summary
• Lack of Financial Slack
– Poor can find themselves at the “edge” of
deep poverty
• Difficulty of small to big transformation
• Lack of buffer stock to deal with shocks
Three Institutions
• Banking
• Payday Loans
• Check Cashing
Unbanked
• Why remain unbanked?
• Channel factors?
– The Federal Reserve Bank conducted a study in 2000
that asked un-banked families why they didn’t have a
checking account. Among top reasons: Do not like
dealing with banks.
• What if…Unbanked due to:
– Nuisances (sneers from teller, no babysitter…),
– unfamiliarity, conscious violation of social norms
• How do we reduce channel factors?
Providing low-fee bank accounts to the poor
(Bertrand, Mullainathan, & Shafir)
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TIFF (Uncompressed) decompressor
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QuickTime™ and a
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are needed to see this picture.
– Prior program proved of limited effectiveness (<50% take-up.)
– Follow-up surveys: 90% intended to, but forgot, misplaced the
relevant forms, etc…
– 2-hour long workshop; If workshop participant interested in FA:
• Referral letter to take to the bank, OR
• Sign up on site if bank representative present at the workshop
Presence of a bank representative: significantly increased opening and
keeping an account, and decreased check cashing, and borrowing from
family.
Take-up: ~8 percentage points higher among those who voluntarily attended workshop.
Take up: ~10 percentage points higher among those who attended workshop where a
Shorebank representative was present.
(Can compare accounts opened at financial educ. workshop vs. tax prep. sites:
No significant differences in closure rates, or in monthly usage patterns)
Cf., Retirement Savings; “Save More Tomorrow” (Benartzi & Thaler)
Deeper Issue
• How do we encourage private sector to
remove channel factors?
• Key policy observation:
– Channel factors are largely unobservable by
regulator
– Suggests outcome regulation rather than
input regulation
Benefits of Banking
• Perspective also suggests something else:
– Why being unbanked can have big
consequences
• Cash on hand vs. in account
• Help with planning
• Access to other financial services that
provide implicit planning and other
automatic behavior
Payday Loans
• Often cited puzzle:
– Poor take out payday loans at rates upward of
7000+%
• Two observations:
– Mental accounting
– Where is the error?
The Calculator Problem
Imagine that you are about to purchase a calculator for
$50. The calculator salesperson informs you that the
calculator that you wish to buy is on sale at the store’s
other branch, located a 20-minute drive away. What is
the highest price that the calculator could cost at the
other store such that you would be willing to travel there
for the discount?
The Computer Problem
Imagine that you are about to purchase a computer for
$2000. The computer salesperson informs you that the
computer that you wish to buy is on sale at the store’s
other branch, located a 20-minute drive away. What is
the highest price that the computer could cost at the
other store such that you would be willing to travel there
for the discount?
The Purchase
Computer ($2,000)
Calculator ($50)
Mean response = $1849.50
Mean response =$26.74
Implied savings: $150
Implied savings: $24
Implications for Payday Loan
Pricing
• People do not evaluate prices in a vacuum
– But relative to other prices or levels
– So is the price of a payday loan 7000%?
– Or is it $10?
Are Payday Loans Bad?
• Recall discussion of lack of financial slack
• From that perspective payday loans are
essential for the poor
– Key problem is not taking out the loan
– Key problem is mis-planning in the past that brought
them to the point where they need a payday loan
– From this perspective reduction in supply of payday
loans would be bad
• Unless it induces poor to plan more—hardly a stronger
incentive than what is already there
Payday Loans
• Suggests that payday loans should
instead focus on:
– Other risk mitigation mechanisms (buffer
stock mechanisms)
– Late fee regulations amongst utilities, etc.
Summary
• Psychological perspective on financial
lives of the poor
• Enriches and complicates our view of role
of:
– Institutions
– Regulation