The Human Economy

We are all human and we will inevitably stretch ourselves to our limits. We ask not how far is suitable, but how far is possible. In some walks of life, applying that hypothetical question is admirable and can lead to great accomplishment. In sports, for example, nobody is ever praised for stopping at "enough." In other walks, it can cause unnecessary stress that leads to collapse. In economics, pushing your finances to their limit will often invite disaster. We are living in the aftermath of this realization right now.

During the housing boom from 1999 to 2006, everyone was in the buying mood, assuming real estate value would continue to climb. When visiting the bank for a loan, home buyers were advised on the maximum amount that they could borrow, but that is a different number than the amount that is appropriate. They were told that they should spend 38% of their monthly income which determined what they could borrow, but what that amount fails to address are all the human tendencies and circumstances that tend to impact a person's budget throughout the life of a loan. Enter the interest-only loan, where the buyer could opt to pay only the interest on a loan while still owing the entire principle amount at the end of the term. With interest-only loans, it was thought that buyers would borrow the same amount and enjoy lower payments and the freedom that they afford. Instead, buyers exchanged that freedom to borrow even more money, bringing their payments in line with what they would be paying on a standard loan. Give a man enough rope and he will hang himself.

We're all familiar with how this story played out. It only takes a tiny mistake or an unexpected illness to come up short on a payment and without any wiggle room,the train starts to come off its tracks.

Economic theory relies on humans acting in a rational fashion, making sound decisions at all times. Unfortunately, not everyone is an economist, nor do they understand the discipline that is expected of them once they commit a large portion of their income to a binding contract. Most of the time, we make what we believe to be a rational decision, but we fail to prepare ourselves for the challenges that will test that rationality in different ways thereafter. We also fail to catch ourselves as we grant exceptions to our impulsive behavior. This is called the planning fallacy and it exists because things never turn out the way we expect them. Despite knowing this, we still continue to plan for the best case scenarios.

We spring for the leather seats, noting that they only add another $20 to our monthly car payment. We borrow that extra $5000 beyond our budget, resolving to work extra hard to cover the burden. We set the bill aside when we get it, feeling that we'll run across it again when we're more motivated to write the check. We ignore the angel on our shoulder warning us about the upcoming management change at our workplace because it is unpleasant to consider when a brand new TV screen is shining in our face.

Despite what economists expect of us, humans are not efficient machines. We are fallible and faulty, prone to mishaps and oversights. This is why we must bridge the gap between standard economics and behavioral economics. To continue assuming the best based on our intentions will lead us deeper into debt. Economic advisers and those in positions of authority operate under the assumption that consumers take measures to make the best decisions. They believe in a self-correcting market and their conservative approach to the world of money makes them unwilling to suggest restrictions on what they believe to be a perfect model. Bankers, on the other hand, understand that the flaws in our economy are where the money is really made.

In the world of banking economics, most profits come from those who skate on the edge of poverty and often stumble. If you've ever wondered why checking suddenly became a free service in the last 15 years, it isn't due to advances in check handling or a well-intentioned perk. It is because the penalties collected on checking accounts with low balances effectively subsidize the operational cost. Overdrafts and low-balance fees paid by the poor support the rest. Credit cards and their associated interest rates and penalties also cash in on those of us with the least amount of cash. One missed payment or a strategically executed deduction before a deposit and BAM! That's another chunk of your money that the bank now owns. With all of this in mind, you figure it would take the jaws of life to pry the banking industry's cold, stiff fingers away from the throats of the poor.

As it turned out, leaning on people with low income and no assets is exactly what came back to bite the banks in the ass. We consumers are the first ones to call for blood in this situation as we see the economy shrink around us, making it harder to live. It is, however, important to understand that the banks fell victim to something a little more innocent than despicable greed. Let's recognize it as human nature. One can understand that rationally, a banker will not make investments that can disembowel his entire fortune without being thoroughly misled about them himself. We all tend to find favorites in the things that benefit us the most when we rely on them and that is how a bad idea can turn into a good one. On paper, interest-only and subprime loans spell out more money potential for the banks. When looking at the positives (money) in this case, it is easy to overlook the negatives (risk). From this we can take the advice that it is not a good idea to allow a lender to advise you on the proper type of loan to take from them. That counsel should come from a third party that does not stand to profit from the decision that they led you to.

The question a lot of people now face is whether to trust economists, or for that matter, the financial industry. We felt it before, but now it is in our face; the banks are not our friends. Our economic culture is not based on what is appropriate, but what is possible (or just out of reach). Mortgage calculators do not tell you what is comfortable, but what is the limit of your potential loan. The financial industry does not profit from your discipline, but from your excess. If given the option to offer a credit card that encourages responsible spending, banks will opt to continue pitching to your impulses. The solution is to take control of your finances, spend only after saving first and avoid as much debt as you can. This, of course, is the most rational path, but don't expect any free vacations or cash back. Nobody likes a rational consumer.