How ‘Human Frictions’ Can Hinder Economic Policy

With little room to cut interest rates over the past two decades, central banks have tried instead to spur economies by speaking directly to consumers. Bank chiefs divulge plans to raise interest rates and hope this translates into clear personal-finance advice: make your big purchases now because credit-card debt and mortgages aren’t getting any cheaper.

Whether the message gets through is an open question, and the answer might hinge on the sophistication of the audience, according to Boston College’s Francesco D’Acunto, Karlsruhe Institute of Technology’s Daniel Hoang, the Bank of Finland’s Maritta Paloviita, and Chicago Booth’s Michael Weber. Their research suggests that policy makers need to account for the fact that some people either don’t understand how certain programs or policy moves could influence their choices, or lack the time and wherewithal to react appropriately.

The findings add a new dimension to economists’ study of the frictions that limit the transmission of fiscal and monetary policy to the real world, the researchers write. They call these challenges human frictions and argue that uneven sophistication among consumers limits the effectiveness of policy interventions targeting households. For instance, their research suggests that people in the bottom half of the IQ spectrum, even when facing no financial constraints, rarely take advantage of policies such as subsidies, “possibly because they are not aware of the policy changes or do not understand how policy measures affect economic incentives.”

“We cannot change consumers’ intellect; but, rather, the ball is in the turf of policy makers, who should design policies in such a way that they are accessible to everyone, not just a handful of expert financial-market participants,” says Weber. Otherwise, policies and guidance can end up redistributing wealth from people who don’t understand the policies to those who do, he adds.

The researchers tapped into the results of IQ testing conducted when Finnish men enter mandatory national service, usually at age 18, and have been mining the data for a series of studies correlating cognitive ability with economic behavior. (For more, read “How central bankers can manage consumer expectations” and “Why central banks need to change their message.”)

In many countries including the United States, scores on intelligence tests and other standardized exams such those required for college are correlated with education and income. But in Finland, education is free through college and the social safety is stronger, Weber says. The researchers find in their data only a small correlation at the individual level between IQ test scores and income, and their results took differences in income into account.

In their human frictions study, they analyzed the response to a cash-for-clunkers car trade-in program run by the Finnish government, probing records of car purchases and registrations. The results demonstrate that individuals with intelligence scores of 1–5 on a 9-point scale were less likely than those with scores of 6–9 to benefit from the program, in which the government offered new-car buyers €1,500 (US$1,700) if they bought a model that met certain energy-efficiency standards. Controlling for income, wealth, and debt, the researchers find that only one in 10 of the buyers with lower scores purchased a car that qualified for the subsidy, compared with four in 10 among the group with higher scores. And, after surveying the same consumers whose choices they observed from public records, they find that most of the differential reaction was due to the lack of awareness and understanding of the policy.