The psychology of the current crisis Stephen Lea Psychology University of Exeter, UK

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 2 Structure of the talk 1.Introduction to economic psychology 2.Money psychology and the recession 3.Debt psychology and the recession 4.Macroeconomic psychology, or what should we do next?

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 3 An apology to my hosts Both theory and data in this talk will be largely based on Western (largely UK and US) experience Economic psychology is still too little informed by material from the new and renewed economies of the world But then, the crisis was itself a product of the Anglo-Saxon financial world...

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 4 The UK Economic and Social Research Councils experts on Dealing with the Downturn (Society Today, Spring 2009) Director of the ESRC International Centre for Life Course Studies in Society and Health Research Fellow at the ESRC Centre for Economic Performance CEO of Shelter (a housing charity) CEO of Oxfam (a poverty/internationl development charity) Director of the ESRC World Economy and Finance Research Programme 2 academic specialists in medieval finance

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 5 So has psychology nothing to say? What we ought to be able to talk about: –What individual behaviours have contributed to the present crisis –How the crisis will impact on peoples feelings, wishes, thoughts, and actions –What individual behaviours could contribute to resolving the crisis The resources we have: –108 years of economic psychology (since Tarde, 1902) –53 years of behavioural economics (since Simon, 1957) And weve been here before: Katona & Strumpel (1978)

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 6 The evidential base So, Im not talking about data from recent studies But this is an evidence-based talk – based on broad well established trends The evidence has been gathered over a century of research, but the pace of work has quickened greatly in the last 2 decades It represents a convergence of approach by psychologists and economists But it has not yet been deployed in the formation of policy (though see recent books by Thaler & Sunstein; Ariely; Akerlof & Shiller; Layard)

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 7 The basic psychological / behavioural position on the economy Contrary to the foundational assumptions of 20 th century theoretical economics, economic behaviour is not completely described by rational choice models Deviations from rationality are systematic and substantial Such deviations can be predicted from known processes in cognitive, social, comparative (and perhaps clinical, developmental and evolutionary) psychology They can be studied in laboratory experiments and the results will be predictive for the real economy An economics (and hence an economic policy) that does not take account of psychological processes and data is radically incomplete

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 8 Looking for deviations from conventional rationality Early work in behavioural decision theory focused on the axioms of rational choice e.g. transitivity. Small deviations from rationality were found, but these were not on a scale to cause any concern to economic theorists From the 1970s on, much larger deviations began to be studied...

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 9 Three major deviations from conventional rationality Heuristics, biases and social influence: people use short cuts to take economic decisions, including taking the views of others into account Fairness, altruism and other norms: people take the outcomes for other people into account when making economic decisions Myopia: people are unsystematic in weighing up outcomes that happen at different times, usually greatly undervaluing outcomes in the more distant future

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 10 Two examples of research programmes in economic psychology Money –Why do we trust it, and why might we cease to trust it? –Why is it such a strong motivator? –What are the limits to its use and why do they exist? Debt –How do people understand debt? –Why do people get into debt? –How does being in debt affect people? –How can people get out of debt?

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 11 Prolific interdisciplinarity Just asking these questions makes it clear that both topics have economic as well as psychological factors We also need to call on data from sociology, anthropology, geography, and other social sciences A tentative generalisation: Once you drop some disciplinary boundaries, they all tend to go

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 12 Why a psychology of money? Money is an intensely strong motivating force but, unlike other strong motivators such as food or sex, it has no apparent or direct biological basis. Money is extremely effective. When non- monetised societies encounter money-using societies, the non-monetised start using money and not vice versa Modern money is fiduciary: it works because people trust it to work. Most people dont understand the basis for their trust. Trust is a psychological and phenomenon, and it is at risk in recessions and other economic crises.

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 13 Money as tool Traditionally, money is seen as an instrument, or tool Individuals use money to gain access to biologically-based incentives, and this is held to explain why they are motivated to obtain money Money makes it easier to trade – it avoids the need for a double coincidence of wants – and hence to gain access to basic incentives

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 14 Money as drug (Lea & Webley, 2006) If money is just a tool, why does it have such direct and sometimes overwhelming effects on behaviour and emotions? Money illusion (e.g. Shafir, et al., 1997) would not arise if people treated money in a rational, instrumental way In some cases, the obvious instrumental uses of money are socially rejected (though they may still happen), e.g.: –Paying for sex (Zelizer, 2000) –Buying children, or bodily organs (Roth, Shanteau) –Giving money gifts to certain relatives, or up a status hierarchy (e.g. Webley et al., 1983) –Repayment for neighbourly help (Webley & Lea, 1993) Anything that bypasses normal instrumental processes and directly causes pleasure or pain can be described as a drug

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 15 Money psychology and the recession Money illusion has probably been important in peoples responses to rising house prices: If you own a house whose price has risen, but all prices have gone up and you still need a house, you are not really better off; but money illusion would make you feel better off If you feel better off, you are more likely to dissave, or to enter into credit arrangements So while the banks are arguably to blame for allowing people to borrow against the increased equity in their houses, basic money psychology is probably what led people to want to take such loans

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 16 The psychology of debt Theoretical driver for a psychology of debt: debt is an example of inter-temporal choice Saving also involves inter-temporal choice, and has long been recognised as problematic for rationality- based economics: people do far less of it than would be rational (e.g. Fisher 1930), a case of Myopia In the 1980s, a detailed psychology of saving was developed to account for this (see Wärneryd, 1999) Saving was one of the first fields in which behavioural economics developed (Shefrin & Thaler, 1988, behavioural life-cycle hypothesis) In economics, debt is treated as the mirror-image of saving, and initially that approach was taken over into the economic psychology of debt

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 17 Credit, debt and problem debt In accountancy terms, any situation where someone owes money is debt But psychologically, we need to distinguish (Lea, 1999): –Credit: borrowing agreed and under control –Debt: money that should have been paid and has not been, but could be (with more or less difficulty) –Problem or Crisis Debt: money that cannot be paid without a major change of lifestyle, and perhaps not even then Viability and value of credit arrangements tend to be assessed in terms of affordability of repayments rather than total cost or APR (Ranyard & Craig, 1995)

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 18 Debt psychology and poverty psychology (Lea et al., 1993, 1995; Mewse et al., in press) The practical drivers for our development of debt psychology: large amounts of intractable debt to utilities & public bodies, and growing dependence on loans in HE (see Scott et al., 2001) The psychology of this kind of debt is closely linked to the psychology of poverty, and the major explanatory factors for debt are economic (low income, high expenditure) The poverty may not be absolute, but relative to a reference group (maybe an inappropriate one) Financial errors are common in young adults: among those with no family resources and poor employment prospects, they may trigger a long career of debt and near-debt People in debt tend to see themselves as poor financial managers – however...

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 19 Coping strategies of poor debtors Typical debtor behaviour can be seen as a set of relatively successful practical and psychological coping strategies, developed over long exposure to a situation from which there is little prospect of escape Maintaining childrens appearances Robbing Peter to pay Paul – abandonment of orderly budgeting Use of high-interest but no-questions-asked door-to- door lenders Adoption of debtor identity Belief that debt is more widespread than it is Smoking – the affordable luxury Unrealistic dreams of escape

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 20 Debt psychology and the recession Anecdotal/journalistic evidence suggests that the recession is producing less familiar varieties of debt: Unemployment / business failure leading to sudden loss of income: debt follows if lifestyle / reference groups not adjusted quickly enough Formerly affordable credit arrangements become unaffordable Acute rather than Chronic debt – a research opportunity? How will people choose between dissaving, changing lifestyle, or taking lower prestige jobs?

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 21 Macroeconomic psychology? Has there been a mass psychology of either money and debt that has contributed to the credit crunch? If so, can that psychology be dismantled or repaired? Would doing so help us find a relatively benign route out of the present economic situation?

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 22 Three disastrous heuristics: The psychology of housing boom and bust 1.Home ownership is always better than renting 2.House price increases make home owners better off 3.If you can afford the repayments, you can afford the loan

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow Ownership and possession The bubble that preceded the crunch was due in part to very high demand for owner-occupancy (1998: UK 67%, France 54%, Germany 41%), partly politically stimulate There are (still) biases in the housing market that favour owner-occupiers However a rational analysis would not support owner- occupancy in many sectors to whom it was being marketed, especially in the US The marginal owners – the 26% who own in the UK but rent in Germany – are those for whom ownership is least likely to be rational At least some people (those high on materialism) feel that owning makes them happy (Belk, 1984), and some of the demand for ownership seems to have no other (rational) basis (Diaz-Serrano, 2009).

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow Rising house prices and the feeling of wealth The sense of increased wealth among owners when house prices rise is a case of money illusion However rising asset prices do give some objective freedom: –Easier loans when you move house –The ability to raise loans against the increased equity These freedoms only work if house prices will (over any medium or long term) never fall There have been times of falling prices within recent memory (e.g. early 1990s), but most borrowers (and staff of lending institutions) had no experience of them Consequently, we had no heuristics available for dealing with a falling market (and probably still havent)

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow The affordable loan People find interest rate calculations difficult, and dont do them In choosing between loans, the salient feature is the regular (weekly / monthly) repayment; in choosing whether to take a loan, the affordability of the regular repayment is the key question This is sensible, but only in a world where nothing can go wrong In many sub-prime loans, the repayments were affordable at first but would never have been affordable later – but here myopia comes in...

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 26 MMM... Recession! Materialism: excess demand for house purchase Money illusion: unwise decisions based on rising house prices Myopia: failure to take longer-term affordability into account This is what needs to be dismantled

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 27 Multiple causation Notice that every one of these trends has a rational as well as a heuristic component There are also always technical issues, e.g. people taking unaffordable loans would have caused only personal disasters if those loans had not been sold on as derivatives that did not recognise their instability All macroeconomic effects follow from a constellation of causes However peoples wishes, their incompletely informed judgements and sometimes misinformed feelings are always part of the story

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 28 The psychology of recovery The Keynesian paradox: –In the long term, a repetition of the present crisis can only be prevented if people save more and borrow less –In the short term, recovery depends on those who can afford it being willing to spend discretionary income Katona: the Better-Better group –People are more likely to spend / dissave if they feel their economic conditions have improved recently and will improve in the near future

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 29 The spreading effects of recession

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 30 Three levels of psychological impact in a recession Direct effects – due to unemployment, business collapse etc. Loss of income and bereavement processes Indirect effects – due to increased risk of being directly impacted, or family / friends losing jobs etc. Increased caution, withdrawal from economy Atmosphere effects – due to media, economic policy, etc. Escapism, conservativive economic choices

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 31 How large are the sectors? Typically the proportion directly affected is quite low Significant numbers are immune – their income is fixed or their employment is unshakeable. They may well be objectively better off in the recession But the boundaries are fuzzy (e.g. friends / family of unemployed people are both directly and indirectly affected) Hence media / policy can influence –How many people will feel threatened –How people who feel immune feel able to behave in ways that will help recovery

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 32 Psychoeconomic policy: How might we influence the scale of the different effects? Build realistic confidence among the unaffected – safety-net jobs, loans and investments where that can be done Selectively popularise high multiplier spending Prepare policies to overcome reverse money illusion in those with negative equity but undamaged capacity to repay a mortgage Support advice etc services who can help prevent acute debt becoming chronic

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 33 Is any of this being done? No

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 34 Envoi: Reflecting on the evidence base This has been a broad brush approach, but detailed evidence exists to support almost every point – see bibliography Most of the data would have been called by C20 economists soft (experiments, surveys) What the recession teaches is that everything in the economy is soft: –Everything that happens depends on peoples confidence in what will happen –Even hard data are meaningless except as expressions of subjective qualities If we had been more ready to learn from the post experience of what was once the Soviet bloc, it would not have taken a recession to make this clear

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 35 Conclusion, therefore: There is no economy without psychology There can be no economic recovery without psychological recovery Understanding the psychology of the recession is not an extra, but an essential Our understanding will be better if we draw on the experience of more of the world, and not just of the West

23rd August 2010Stephen Lea: ICABEEP Summer School, Moscow 36 References and further reading Ainslie, G (1992). Picoeconomics. Cambridge: Cambridge University Press. Akerlof, G. A., & Shiller, R. J. (2009). Animal spirits. Princeton NJ: Princeton University Press. Ariely, D. (2008). Predictably irrational. London: Harper Collins. Belk, R. W (1984). Three scales to measure constructs related to materialism: Reliability, validity, and relationships to measures of happiness. Advances in Consumer Research, 11, Diaz-Serrano, L. (2009). Disentangling the housing satisfaction puzzle: Does homeownership really matter? Journal of Economic Psychology, 30, Fisher, I (1930). The theory of interest. New York: Macmillan. Gigerenzer, G., & Todd, P. M (1999). Fast and frugal heuristics: The adaptive toolbox. In G. Gigerenzer, P. M. Todd, and the ABC Research Group (Eds.), Simple heuristics that make us smart. New York: Oxford University Press. Gintis, H., Bowles, S., Boyd, R., & Fehr, E (2003). Explaining altruistic behavior in humans. Evolution and Human Behavior, 24, Katona, G (1975). Psychological economics. New York: Elsevier. Katona, G., & Strumpel, B. (1978). A new economic era. Amsterdam: Elsevier. Lea, S. E. G (1999). Credit, debt and problem debt. In P. E. Earl & S. Kemp (Eds.), The Elgar companion to consumer research and economic psychology, pp Cheltenham: Edward Elgar. Lea, S. E. G., & Webley, P (2006). Money as tool, money as drug: The biological psychology of a strong incentive. Behavioral and Brain Sciences, 29, Lea, S. E. G., Webley, P., & Levine, R. M (1993). The economic psychology of consumer debt. Journal of Economic Psychology, 14, Lea, S. E. G., Webley, P., & Walker, C. M (1995). Psychological factors in consumer debt: Money management, economic socialization, and credit use. Journal of Economic Psychology, 16, Loewenstein, G (1996). Out of control: Visceral influences on economic behavior. Organizational Behavior and Human Performance, 65, Mewse, A. J., Lea, S. E. G., & Wrapson, W. (in press). First steps out of debt: Attitudes and social identity as predictors of contact by debtors with creditors. Journal of Economic Psychology. Ranyard, R., & Craig, G (1995). Evaluating and budgeting with instalment credit: An interview study. Journal of Economic Psychology, 16, Ranyard, R., Hinkley, L., Williamson, J., & McHugh, S (2006). The role of mental accounting in consumer credit decision processes. Journal of Economic Psychology, 27, Richins, M. L., & Dawson, S (1992). A consumer values orientation for materialism and its measurement - scale development and validation. Journal of Consumer Research, 19, Scott, A. J., Lewis, A., & Lea, S. E. G. (Eds.). (2001). Student debt. Bristol: Policy Press. Shafir, E., Diamond, P., & Tversky, A (1997). Money illusion. Quarterly Journal of Economics, 112, Shefrin, H. M., & Thaler, R. H (1988). The behavioral life-cycle hypothesis. Economic Inquiry, 26, Simon, H. A (1957). Models of man. New York: Wiley. Tarde, G (1902). La psychologie économique. Paris: Alcan. Thaler, R. H (1988). Anomalies: the ultimatum game. Journal of Economic Perspectives, 2(4), Thaler, R. H., & Sunstein, C. R. (2008). Nudge. New Haven CT: Yale University Press. Tversky, A., & Kahneman, D (1974). Judgement under uncertainty: Heuristics and biases. Science, 185, Webley, P., Burgoyne, C. B., Lea, S. E. G., & Young, B. M (2001). The economic psychology of everyday life. Hove: Psychology Press. Webley, P. & Lea, S. E. G. (1993). The partial unacceptability of money as repayment for neighbourly help. Human Relations, 46, Webley, P., Lea, S. E. G., & Portalska, R. (1983). The unacceptability of money as a gift. Journal of Economic Psychology, 4, Zelizer, V. A. (2000). The purchase of intimacy. Law and Social Inquiry, 15,