Thursday, 25 August 2011

How rich do you feel?

If there is one thing the public school system should be able to achieve, it is to produce adults capable of simple arithmetic. So why are so many of us, including so many with professional degrees and 6 digit salaries, awash with debt? We know how to add up - the costs of our consumption - and we know how to subtract that total from our income and see whether the result is positive or negative. But we just don't do it. Rather we spend according to how rich we feel.



Budgeting is a constrained maximisation problem. Your resources are fixed, and your task is to use them in such a way as to maximise what you can get with them. Economists call this constrained maximisation rational choice, and expect that it will force consumers to order their preferences in terms of the subjective value of their satisfaction. So, if you have only 1 dollar then you will have to choose between the chocolate bars on offer at the vending machine, and you are rational if you choose the one that you expect to enjoy the most. Likewise, if you have 50 dollars to spend on your weekly grocery shopping, you should select the bundle of food products that you will enjoy the most and can still afford. This is all rather obvious and one of the least controversial normative claims of contemporary economics.

But it is eminently clear that most people in modern consumer societies do not budget and as a consequence many of us fall into debt. Why? Some commentators argue that the rise of plastic credit makes the arithmetic of budgeting more complex. Or that this is the consequence of being hardwired by evolution to act impulsively (hyperbolic time discounting, in the parlance of behavioural economics). Others claim that a cult of consumerism permeates our society and our values like a new religion and makes us want things we can't afford. Or that evil credit card companies seduce the vulnerable with confusing small print. Yet others argue that our society as a whole has made a pact with the devil, to borrow from the future (and perhaps, our children's future) for immediate gratification. A pact that is unsustainable, by definition.

All these seem true and relevant, but not fundamental. A central mechanism rarely considered is the switch we have made from budgeting as an accounting exercise to budgeting as projection of our identity. We do not count what we spend anymore. Instead when we consider a purchase we think about who we are. We ask, Am I the sort of person who can afford to buy this expensive bottle of wine or this new car? Yes, I'm a doctor with a successful practice, we answer, or perhaps, No, I'm still a student in medschool. Maybe in a few years.

Now this heuristic drastically simplifies the whole laborious counting and subtracting thing. But the mental shortcut it provides is rather unreliable. Two kinds of failures in particular stand out: aggregation and volatility.

The aggregation problem arises because we confront each purchasing decision separately rather than together (as with the accounting approach). It may well be true that you're a moderately rich person and can afford a moderately expensive restaurant dinner with a good wine. The heuristic says go ahead. But can you afford to do that 4 times per week? This is outside the scope of the heuristic. Consider how surprised one often feels looking through a credit card statement at the end of the month. How did you manage to spend that much when all your purchases were so reasonable?

The volatility problem arises because how rich you feel is part of your identity and only indirectly linked to the fundamentals - your actual wealth and income. That means it is linked to how successful you feel at any particular moment. For example, after making a 3 pointer in basketball you may spend the next hour or so walking with a swagger, and feel like a more successful person. Unfortunately your wealth isn't linked to such successes, even though they are tied together in your mood.

How rich you feel is also linked to who you feel as successful as. This is your reference status group. Depending on which group you feel you are (or should be) a member of, you will take different consumption habits as a benchmark of reasonableness for a person like you. If you think of yourself as a successful person, you will think of yourself as being able to afford the kinds of things successful people have, and vice versa. I'm a hot shot doctor. Hot shot doctors buy a new car every year, so that's what I can afford.

(Note that given the self-deluding bias of the human concern to better our condition, it is also rather common for people to try to promote themselves to the class of hot shot doctor by buying the fancy car. In a sense this can be thought of as making a material commitment to the achievement of one's aspirations - if I act like the kind of person I want to become, I will really become that person - though of course there is always the risk that those aspirations are based on a delusion about one's fundamental abilities.)

Finally, the behaviour of your reference status group will be subject to the influence of social fashions and seasons. Fashions are arbitrary - like the popularity of SUVs in America in the early 2000's, or burberry among the British lower middle class. Seasons reflect underlying changes in something fundamental (the amount of sunlight fueling the whole enterprise).  Thus, in the current crisis even those whose income fundamentals are unchanged perceive that people like them are spending less, and less conspicuously, and have downgraded their consumerist presumptions by a notch or two to match. Austerity chic.

The way out is obvious and not particularly cognitively difficult. Poor people living on volatile incomes averaging a dollar a day have to think carefully about every penny they spend. We are fortunate enough to think in dollars not pennies, but the principles are the same. Do some calculations about your income and your necessary outgoings - groceries,utilities, rent, etc - and calculate what else you can afford to spend, on leisure. Then don't spend more than that. You will find it hard at first to accept the authoritarian control of your accounting book. Your aspirations and freedom to define yourself may feel cruelly constrained. Having to say no to your impulsive wants may be emotionally draining. However rich you actually are, you may feel poor. But after a while you may come to appreciate the scaffolding this way of life provides to help you make better decisions. Remember, the other side of constrained maximisation is maximisation, and it is only when you have to face up to your real constraints, like a rational grown up, that you will really reflect on your priorities and their relative importance. You will find that you will actually be freer to spend what you have (your time as well as your money) on the things you yourself value most, than you were when you adopted and followed a social identity that told you what you should value and do.

2 comments:

  1. Interesting thoughts on American budgeting troubles. I think your notion about emotional budgeting (that based on feelings of worth or wealth rather than actual numbers) is insightful, though it's possibly just a reformulation of the "keeping up with the Joneses" aspect that has long been a distinct feature of American household finance.

    There's also the dimension of time to consider. As people hold fewer life-long jobs these days, it stands to reason their average income will vary more over their lifetime than it did for past generations. Thus, they will need to adjust their budget more often than their parents did as they take on different jobs, move around more, etc.

    Also, as a young American, I've got to say that budgeting gets almost completely overlooked in scholastic education. I had one week-long unit about personal finance in my life management sciences (LMS) class in 8th grade; that's the only time I was ever actually taught this CRUCIAL life skill from elementary school all the way through college.

    Finally, it strikes me that American problems with budgeting could be a largely ignored, yet fundamental cause of the aggregate economic dysfunction everyone is experiencing now. If each individual were just a little bit smarter about his or her money or even just had some sort of baseline standard conception of how to budget properly, our overall economic situation would probably look A LOT better.

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  2. Thanks for commenting, Taylor.

    Indeed one can extend the identity analysis to the economic crisis level. A liquidity crisis is when everyone feels rich and is puzzled that no-one else seems to want buy their stuff for as much as they feel it is worth. Insolvency is when people start to realise that their assets are actually crap and feel that they are in fact poor. e.g. Greece

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