Just as lawmakers were throwing consumers into the shark-infested ocean of new borrowing opportunities, cognitive psychologists and behavioral researchers were uncovering systematic hindrances to consumers’ attempts to swim in this ocean.   These behavioral scientists revealed compelling evidence of cognitive illusions (biases) and mental shortcuts (“heuristics”) that systematically and predictably skew individuals’ analysis of probabilities, choices, and behavior in ways inconsistent with logic and welfare maximization.  

The behavioralists do not claim that people act “irrationally,” but rather that people act in ways that systematically and predictably diverge from the “rational choice” model of traditional economic analysis.  People thus inadvertently fail to maximize their own future utility—not because they are irrational, but because their rationality is “bounded” by documented and consistent biases and mental shortcuts.  These “bounds” of rationality affect behavior in a variety of contexts, particularly contexts involving many complex variables and ambiguous, unpredictable consequences of any given choice—like consumer borrowing.

Scholars in a variety of legal areas have rushed to this new analytical vehicle to explain or support their predictions and prescriptions.   Thomas Jackson’s landmark analysis of bankruptcy policy led the way in behavioral economic analysis of bankruptcy law.   Very little work since then has applied behavioral economic insights to consumer overindebtedness and consumer bankruptcy.   But then the discipline is quite new.  As one behavioralist scholar observed in 1998, “[w]e are at the beginning of behavioral law and economics.”

Behavioral economics offers compelling insights into the tendency of consumers to accumulate “too much” debt when freed from the constraints of legal credit restrictions.  Many behavioral insights are not particularly relevant to an analysis of consumer overindebtedness and its “treatment,” but several are astonishingly apt.  For example, behavioral findings suggest that consumers suffer from consistent overconfidence, they systematically gauge risk inaccurately based on information readily “available” to them from memory, and they succumb to “bounded willpower” in severely underestimating future costs and overvaluing present benefits.  Thus, behavioral economics offers compelling explanations for why consumers so often underestimate the possibility that they will be unable to meet their future credit obligations with future income, and why they so often fall prey to the powerful siren song of present benefits while all but ignoring future costs.  If the supply side of consumer credit is unconstrained, behavioral economics reveals that powerful forces render control of the demand side virtually impossible.

A.  The Overconfidence Bias

Individuals tend to be overly optimistic and overconfident regarding their own susceptibility to risk.   Specifically, people systematically underestimate their own chances of suffering an adverse event, even if they understand perfectly well or even overstate the probability of others suffering the same fate (“It can’t happen to me”).  People of all social categories are prone to overconfidence in their own judgment and susceptibility to risk, even those who are more informed about the actual statistical probability of adverse events.   This overconfidence bias is exacerbated by the “illusion of control,” which leads individuals to overestimate their ability to avoid negative events by controlling their own behavior (“I’ll never have a car accident—I’m a good driver”).