Nudges

Just a brief post:

In recent news, attention was brought to the changes in the way people manage their money as a result of the shaky economy. Surveys suggest that the average proportion of the household income put aside as savings remained relatively constant in last four years. At the same time there seems to be a strengthening trend to pay off credit card debts and loans.

In purely economical terms, this situation can be difficult to explain. The choice to spend more on paying off a mortgage, for instance, should appear as less attractive than simply saving money, from a rational standpoint. The idea to pay off the debt is an “investment” with no fluidity, in contrast with saving account from which the money can be withdrawn if there is a need to do so. At the same time, speeding up on paying your loan increases the already existing transaction costs, whereas saving accounts don’t require regular payments (unless we are talking about a saving scheme/fund). Strictly speaking, saving up money, at first glance, appears to be the most appealing and safest route given how uncertain the economical future is.

However, a possible explanation for the current situation could be extracted from the book “Nudge” written by two extraordinary psychologists/economists; Richard Thaler and Cass Sunstein. Two authors elaborate on the subject of temptation and possible strategies that people can adopt as a condition to avoid unnecessary spending. Some techniques can be internal (like mental accounting) and involve our personal determination in managing our finances. Very often, however, people tend to use external devices such as saving schemas or pension programs. Many of these methods are in fact self imposed limitations and rules that make us stick to our long term plans. In fact, people do this all the time, as if they anticipated their poor and unstable judgment! Sometimes, we are aware of our weaknesses and would like to take precautions so that we don’t get in trouble later on. A great example of this phenomenon is the new initiative run in Nevada, USA. Knowing how many people have a gambling problem, a new registry of banned from casinos individuals has been formed. The key element is that people are allowed to put themselves on this list, if they feel that they have a gambling addiction. Amazingly, loads of people take an advantage of this system!

Going back to the British economy, self regulation could explain why people prefer to pay off their debts, rather than saving up for the unexpected. Accordingly, it appears that because of the unclear economic situation, people need to refrain from unnecessary spending. As we know, money can be withdrawn freely from a bank account so people may be tempted to use it on, let’s say, Christmas presents. However, lowering the amount we own is a sensitive strategy to locate our money, if one thinks about the future. Many loans, like mortgages, don’t have a fixed interest rate so they can be affected by the economical situations. Therefore, people don’t want to be in debt, and don’t want to waste money if they feel a strong urge to do so. Conclusively, increasing our mortgage repayment could be regarded a self controlling external device.

In my opinion, this seems to be plausible explanation for the current state of affairs.