If the government wants people to save more it will have to look beyond first year economics. Full information and homogenous products are no antidote to imperfect human nature
I bought a car last year. I didn’t want a long explanation of how a car works and didn’t have to listen to one. I formed the impression that the friendly and helpful man who sold it to me was trying to persuade me to buy the car he was selling, rather than to give me impartial advice on my transport needs. I even suspect – although he didn’t tell me – that he might have received a commission on his sale. I didn’t mind. It was a competitive price and a good car.
What makes financial services different? Financial services are complicated; they are long-term purchases and the costs of making bad decisions are high. But all these things are also true of cars. It is a lot easier to describe a bid offer spread than to explain how a carburettor works. The designed life of a modern car is 15 to 20 years, though many people dispose of them after three or four. And a bad car threatens your life: a bad pension plan will damage only your wealth.
The car market does not work perfectly. There are dodgy dealers; and trading standards officers are regularly involved in putting the worst of them out of business. We have approval requirements to guard against unsafe design and tests to keep dangerous cars off the roads.
Car manufacturers sell new cars on tight margins and hope to regain profits on spare parts. They sell us gizmos we do not need. But on the whole, the car market does not work badly. We do not have a constant stream of enquiries into the car market, as we do for financial services.
The government and regulators of the financial services industry seem to have in mind the model of the economy taught in first-year economics courses, in which rational consumers choose between competitive producers of homogeneous products in an environment of perfect information. The outcome is always efficient.
At good universities, these assumptions are relaxed in successive years of the course. Postgraduate students today learn about behavioural economics, which looks at what people really do instead of imposing assumptions of rationality on them. They understand that competition is imperfect, products have many dimensions and information is limited; and that in these conditions the outcome is not necessarily efficient at all.
But somehow the analysis of financial services does not seem to have got that far. If the world is not like the model described in that first-year economics course, the regulators must change the world until it is. If consumers are not well informed, they must be given more information. If they will not read it or cannot understand it, the product must be simplified until they can.
It is desirable that there should be simple, low-cost financial services products. But they will not be widely bought. The Monopolies Commission told detergent manufacturers they must produce good quality, good value products without fatuous advertising. But Square Deal Surf failed in the marketplace. Consumer needs in the modern economy have many facets. Unilever and Procter & Gamble knew what they were doing when they bought expensive television slots for Persil and Ariel.
Modern business produces ever more complex products with ever more simple functionality. My car is far more sophisticated in design than the equivalent model 20 years ago, so that I never have to look under the bonnet. The electronic camera enables amateur photographers to point and shoot. The genius of Steve Jobs was to see that the future of his industry lay in computers that you could use without understanding anything about computers. And to achieve that, he devised a highly complex product.
Consumers will not be well served by giving them lots of information that they do not want, or by simplifying products so that they can be more easily understood. The market economy deals with complexity not by elaborate explanation but by encouraging buyers to rely on the reputation of their supplier in developing products that meet their needs.
What has really gone wrong in the financial services industry in the past two decades has been the readiness of providers to sacrifice reputations. Aggressive short-termism encouraged them to sell products without concern for the integrity of their relationships with customers, or the ultimate effect of their behaviour on their reputations.
This was equally true of the insurance companies that missold personal pensions, the investment banks that puffed dotcom stocks, the accountants who told their clients whatever they wanted to hear and the fund managers who bought each other’s split capital shares. As we see today, none of these activities was in the long-run interests of the businesses concerned but, in the meantime, they did wonders for the bonuses and earnings of individuals and firms.
The short-term outlook of the industry is matched only by that of its customers. We are perennially optimistic, unduly confident of our own judgment and preoccupied with the present. It is not surprising that 93 per cent of customers choose active fund managers, even though on average they underperform. Ninety per cent of the population have bought lottery tickets, although for the most part they lose. It could be you – but it usually isn’t: still, the prospect that it might be keeps us going.
It is not difficult to understand why fund managers compete on past performance, not on charges. Or why they trade products, such as securitised lending and split capital shares, that they do not understand themselves. And the only way you will make people aged 30 save enough for their retirement is to compel them. You won’t change imperfect human nature by giving it more perfect information.