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We're Too Dependent on Debt


Mark Howard,
Executive Editor

Traditional economics has always had trouble explaining the way markets and people actually behave, particularly when people make decisions that involve weighing short- and long-term costs and benefits. One example involves 401(k) plans. The plans are, by any measure, a great deal for workers — the law allows them to use tax-deferred earnings to save for retirement. In addition, they get free money from the company in the form of their employers’ contributions to their accounts. Yet despite all the clear benefits, workers tend to leave money on the table. According to Harvard Magazine, research shows that it takes the average employee two to three years to enroll in a company’s 401(k). Up to half the workers older than 59½ — the age when they can withdraw money from a 401(k) with no penalty — aren’t enrolled, according to a researcher quoted by the magazine. What’s up? The answer seems to be that people tend to exaggerate the short-term inconvenience of enrolling (paperwork, investment choices) and undervalue the long-term benefits. It’s a scenario familiar to anyone who plans to begin saving, or to eat better, or to begin exercising. We understand that those activities are, in the long run, very good for us. But in the short run, we tend to start them tomorrow.

Such behavior vexes traditional economists because it reveals people clearly not maximizing their own self-interest — which, according to traditional economic theory, shouldn’t happen.

Over the past couple of decades, a new academic discipline called “behavioral economics,” a kind of blend of psychology and economics, has attempted to move economics closer to the real world and what we all know — that we don’t just
rationally think through all the information at hand and make unemotional, well-informed choices.

One key principle identified by behavioral economics is that people often use rules of thumb to make decisions rather than precise analysis. Another principle, well understood by anyone in the advertising business, is that the way our options are presented to us — how our choices are “framed” — can influence our decision as much as our analysis of the options. In the case of 401(k)s, for example, workers enroll sooner and stay enrolled longer when companies automatically enroll them as soon as they’re eligible. Instead of having to opt into the plan, workers have to choose not to participate. The costs and benefits are the same, the choice of whether to participate is the same, but the different “frame” produces different results — better economic results for the employee. Another example of framing, which businesses use to their advantage, is offering customers an automatic payment plan, with payments deducted from the customers’ bank account each month without the customer having to write a check or go online and make the transaction.

Among those who identify themselves as behavioral economists are Larry Summers, the former president of Harvard who’s the director of President Barack Obama’s National Economic Council. Other Obama advisers, and Obama himself, according to reports, are fans of the discipline. Not surprisingly, behavioral economics are showing up in some policy initiatives by the Obama administration. The recently passed credit card legislation that requires banks to spell out how long it will take consumers to pay off their balances using the “minimum payment” shows a touch of influence from behavioral economics.

More notable is the president’s proposal for a “tax-free universal savings account” for all Americans — what some call an “automatic IRA.” Obama envisions a system where about 3% of every worker’s wages would be diverted into a retirement account as the worker’s paychecks are direct-deposited into the bank. Employers, according to the New York Times, wouldn’t have to do anything aside from choosing the IRA plan. The Obama administration hopes the plan will boost savings rates among lower- and middle-income workers and envisions matching some of the workers’ contributions with cash or existing tax credits. A central feature of the plan is the behavioral-economics approach to enrollment: Workers would be signed up automatically and would have to opt out if they don’t want to participate.

The details will be tricky — small-business groups are worried about paperwork and liability issues, among others. But in a state with substantial numbers of lower-paid service workers and lots of small businesses that can’t offer 401(k) plans, a systematic way for all workers to save could be welcome.

And there are reasons to think that Americans are more willing to save these days. Having bumped along at 1% or less for most of 2006 and 2007, the savings rate began climbing as the recession took hold and climbed above 5% in April for the first time since 1995. Some Florida banks report that more than half of their new-account customers are opening savings accounts.

That trend may be explained more by short-term uncertainty and workers’ fear of losing their jobs rather than the re-emergence of good old-fashioned thrift, but at some level it doesn’t matter. Government obligations — through middle-class entitlements like Social Security, Medicare, civil service pensions and the like — are rapidly approaching the point where some kind of major retrenchment or even a collapse of the middle-class welfare state is inevitable. The current and coming generations of wage earners face grim prospects: They’ll be forced to pay increased taxes to cover obligations to previous generations — and, simultaneously, they’ll need to save to make up for what the government will be unable to provide them as they age. Indeed, Obama’s “automatic IRA” is both necessary and hypocritical at the same time — even as the president would have us all begin to save more, his administration has expanded spending beyond our means on a scale that is staggering. And more than a dose of behavioral economics will be needed to fix that problem.

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