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Consumer behaviour and the GFC

By Ian McAuley - posted Monday, 7 March 2011


Understandably, as we reflect on our escape from the global financial crisis, most media and policy attention has been concerned with the financial institutions themselves. It is informative, however, to consider how individuals – you, I, and 22 million other Australians – have interacted with the finance sector, and whether we have made the best adjustments to our behaviour. After all, we should remember that this crisis stems largely from imprudent borrowing by households. The banks needed the help of American households to bring on the GFC.

In the USA housing interest rates have been on a roller coaster ride since the turn of the century. In response to the "tech wreck" of 2000 official interest rates were lowered to absurdly low levels over the following three years. Households responded to the availability of cheap loans, and, as the cliché goes, the rest is history.

We may say it was irrational for people to have become so overcommitted, but such over-commitment is normal in housing markets. When we take a mortgage, the decision rule governing the amount we borrow is usually related to immediate affordability – such as a repayment commitment of no more than 25 percent of income. (Even these decision rules were bypassed by many of America's sub-prime spruikers.)

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When interest rates are abnormally low such rules can lead to over-commitment. But even in more normal times we tend to become over-committed, because we are over-confident about our ability to repay a loan. Research in behavioural economics reveals what is known as the "Lake Woebegone" effect: almost all of us consider ourselves to be above average in our abilities as cooks, drivers, lovers and financial managers, and we ignore risks such as unemployment, illness, or a fall in house values.

In times past this bias was offset by inflation – in the days when five to ten percent inflation prevailed. We may have been over-committed in the first year or two of our mortgage, but over time our nominal income rose as a result of inflation, while the amount outstanding on our mortgage, denominated in pre-inflation dollars, fell in real terms. Modest inflation saved us from our own folly.

In a low inflation environment, however, that offsetting mechanism no longer operates – which is one reason why American authorities are so anxious to see some restoration of inflation; a period of deflation would make the matter so much worse, as has been the experience of Japan over the last twenty years.

Australia has been far more fortunate in that we have had a sustained shortage of housing, supported by immigration, and much more stable interest rates. (Our misfortune has been unaffordable housing.) Politicians like to raise the heat about interest rates, but, rhetoric aside, our Reserve Bank has kept our real housing interest rates – the interest rate after inflation – within a tight band around 4.5 percent ever since the Howard Government, early in its term of office, granted a large degree of independence to the Reserve Bank. Although this has been one of our nation's most significant economic reforms, the Liberal Party tends not to celebrate it, presumably because stressing the Bank's independence would distract from political claims about interest rates "always being higher under Labor".

Our households therefore have largely avoided becoming overcommitted in debt. In fact, one development which has taken policymakers by surprise has been an outbreak of financial conservatism among households. We have started saving again. A generation ago, in the early 1970s, saving was the norm; we were putting aside up to twenty percent of our income in savings. Over the following decades credit cards, car loans, and mortgage re-draw facilities became more widely available, and by early this century we were actually spending more than we were earning.

But saving is once more fashionable, and this seems to have been a response to the GFC. The official data is in the Reserve Bank's statistics, but anyone who has been to the shops in the Christmas-New Year period, seeing their extraordinary promotions, would be well aware that people are not spending freely.

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In all, a retreat to financial conservatism is a wise move economically. In countries like the USA or in economically integrated regions such as Europe, consumer conservatism creates a dangerous feedback cycle of low demand on domestic industries. In our case, however, because we are so reliant on imports, that is not such a significant problem. In fact, it may help redress our fairly serious imbalance in our current account with the rest of the world.

Another benefit is that if we have become more financially conservative we are less likely to be sucked in by "too good to be true" offers, such as those which were promoted by the now bankrupt Storm Financial Services, and are less likely to have to pay for very expensive credit, such as credit card interest.

Yet, conservatism can have its own costs. While financial recklessness can lead to quick ruin, hyper-conservatism can lead to slow poverty. Behavioural research shows that we are much more concerned about potential losses than about missed opportunities for gain. (In economists' terms, we tend to discount or ignore opportunity costs.)

For example, many people on learning about the poor performance of their superannuation policies following the GFC may be tempted to opt for "safe" superannuation policies, such as cash or "capital stable" portfolios, particularly if they have experienced negative returns.

Yet these products are unlikely to do any better than inflation, once fees and commissions are taken into account. Over 40 years of contributing to superannuation, the cost of choosing a "safe" low-yield portfolio can be enormous; it can be the difference between a comfortable retirement lifestyle and dependence on the age pension. (One can see the effects of different fees and returns by use of a spreadsheet model developed for this purpose.)

The other area where financial conservatism can be misplaced is insurance.

The Victorian bushfires in 2009 and the more widespread flooding this year have brought to our attention problems in insurance – definitional issues around what constitutes "flood" damage, and the plight of those who have been entirely uninsured.

The problem of under-insurance is more complex than it appears at first sight, for behavioral research indicates that it is quite normal for people to be both under-insured and over-insured at the same time.

Behavioural research gives some insight into this contradictory situation. We tend to compartmentalize our perceptions of risks, and rarely take into account our whole financial situation. By mid 2010, Australian households held about $900 billion in financial assets – deposits and shares – not including superannuation. That's almost $100 000 a household of reasonably available funds to cover contingencies – minor household repairs, write-off of an automobile with a low book value, minor burglary and other misfortunes.

That's an average figure, and most households have much lower levels of liquidity, but we should reasonably expect that the better off people are financially, the more they would self-insure, for insurance is expensive. That is, we would expect people to use their own savings to cover minor contingencies. Of what we pay in general insurance – house, contents and motor vehicles – only 70 cents in the dollar comes back in the form of settled claims; the rest is accounted for by profits, administrative costs and re-insurance premiums paid by insurance firms.

Yet, research shows that self-insurance is unusual. The higher our income, the more likely we are to pay insurance companies to cover our risks, and the more likely we are to buy expensive policies with zero or very low deductible amounts. Justin Sydnor, of Case Western University, calls this "sweating the small stuff", and he points out that we pay very dearly for such over-insurance. It's not only the very well-off who buy such policies; people of more modest means buy insurance to cover such low-cost events as electric motor fusion, and even to cover funeral expenses – perhaps the only misfortune with 100 percent certainty.

At the same time as we take unnecessary insurance for minor contingencies, we are likely to leave ourselves entirely uncovered for other more serious events. Behavioral research shows that we are very poor at understanding the nature of risk, and that we consider risks in isolation. For example, most of us will know of people who are obsessive, say, about bacterial cleanliness, but who subject themselves to high risk through careless driving or poor diet.

Such compartmentalization is normal, if irrational, behaviour. It explains, for example, why we may try to cover ourselves completely against the cost of an automobile accident, even though the zero-deductible policy is very expensive, while leaving our house comparatively uninsured.

In fact, there are no insurance policies on the market that offer significant risk-sharing for consumers. For example, the highest deductible offered by most firms on domestic buildings is only $1000. Even Choice, the supposed source of sound consumer advice, advocates that people should not take out policies with high deductibles, because if they do "it will rarely be worth making a claim for minor damage". We have built for ourselves a culture of expensive over-insurance, displacing any notion of prudent self-reliance.

Now one would think it would make good sense for insurers to offer risk-sharing products. Imagine, say, a house policy in which the insured person had an excess of $100 000. It should be possible for insurers to offer such policies at a low price, for they would avoid the administrative costs of small claims, and they would have a strong assurance that the policy holder has a high stake in looking after the property - low "moral hazard" in insurers' terms. And, of course, for those who find insurance expensive, the pain of having to find $100 000 in the event of a catastrophe is far less than the pain of being completely uncovered.

So why are such risk-sharing policies unavailable?

The short answer is that they don't fit the industry's adopted business model. Such policies may be actuarially attractive, but they don't provide the cash flow of the "small stuff". Those who control firms don't simply seek profit; they also seek growth. It's more fun and more financially rewarding being the CEO of a big company with modest profit than being the CEO of a small company with high profits.

More importantly, the "small stuff" provides a buffer against risk, for insurance firms are intrinsically risk-averse. Insuring cars, for example, is low-risk predictable business, for car accidents don't vary much year to year. Houses are a different matter, for natural catastrophes do not behave in a neat statistical distribution, and there is no means of predicting the effects of climate change.

Thanks to a combination of consumer biases, and the industry's risk aversion, we have an insurance market that operates in exactly the opposite way in which it should. While it makes sense to take responsibility for minor contingencies from our own resources, rather than paying a high-cost financial intermediary, it would make sense if we could find insurance for those things we cannot afford to replace, while we accept the benefit of a large gap or co-payment. (This is the way corporate insurance works.)

Instead, that model is turned on its head. Insurers, by various means including exclusionary clauses and payment limits, cap their own liability while leaving consumers exposed to the open-ended risk. They are willing to cover things we can cover ourselves, but not to cover risks that can leave us devastated.

Catastrophes over the last two years have brought those problems to our attention. Many will complain about what they see as unconscionable behavior by insurance firms, but that is to ignore the incentives in a competitive industry and the biases in consumer behaviour. There is a fundamental market failure, requiring policy intervention, by way of regulation of government provision. Failure in insurance markets may not have the world-wide consequences of the GFC, but for those who have lost their houses or livelihoods the consequences are many times more severe.

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The main findings of behavioural economics are in a CPD paper "You can see a lot by just looking: Understanding human judgement in financial decision-making".



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About the Author

Ian McAuley lectures in Public Sector Finance at the University of Canberra and is a Centre for Policy Development Fellow.

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