The Economic Psychology of Saving and Debt

Paul Webley

Talk to Economic Psychology seminar group, Autumn 2002

Outline of talk

1. Some background (Keynes, Katona, Thaler etc)

2. Two routes into problem debt (a panel study in Holland)

3. What lies behind saving motives? (a questionnaire study in the UK)

4. Saving and individual differences (a questionnaire study in the UK)

5. Saving, individual differences and reference groups (a questionnaire study in the UK and Italy)

Some background from Economics• Saving is an area where Economists have

made an explicit appeal to psychology to explain behaviour: debt and borrowing have been of less interest - they have just seen as the opposite of saving.

• Keynes was not only a great economist, he was also a reasonable psychologist: and his list of 8 motives for saving has stood the test of time (only one has been added)

To build up a reserve against unforeseen contingencies

(the precautionary motive)

To provide for the anticipated future relationship between income and needs (the life-cycle motive)

To enjoy interest (the inter-temporal substitution motive) [K said this was unimportant]

To enjoy a gradually improving expenditure (the improvement motive)

To enjoy a sense of independence and power to do things (the independence motive)

To secure a masse de manoeuvre to carry out speculative or business projects (the enterprise motive)

To bequeath a fortune (the bequest motive)

To satisfy pure miserliness (the avarice motive)

Most economic theories of saving concentrate on motive 2 (the most obvious reason for saving today is to spend tomorrow)

Modern theories e.g. Carroll’s buffer-stock model also focus on motive 1 (the need to have a reserve for emergencies)

Either way, just about all economic models of saving assume optimisation.or utility maximisation over the life-span. The life-cycle hypothesis says that saving at any stage of a person’s life-cycle can be predicted from his current income and wealth, expectation of future income and life expectancy, by finding the stream of consumption

that will maximise utility. So you’d expect something like this …..

Schematic diagram of ‘hump’ saving

0

10

20

30

40

50

Spending

Income

Saving motives across the life-span

• Some psychological data that are relevant to these economic ideas come from the Dutch socio-economic panel

• This shows that being prepared for emergencies (having a ‘buffer’) is indeed the most important motive for saving at nearly all ages

Note: The relative unimportance of saving for old age probably reflects the quality of pension provision in Holland

What Economic Psychologists say

By contrast economic psychologists have suggested

(i) Saving is not a unitary phenomenom (Katona makes distinctions between discretionary and contractual saving and between voluntary and involuntary saving)

(ii) most people have a self-control problem - saving is actually difficult to do

(iii) saving involves forming expectations about the future (especially future income) - which is not straightforward

(iv) the assumption of fungibility (that all wealth is equivalent) is wrong. Thaler has proposed that people have different mental accounts, and based on this, a behavioural life-cycle model of saving.

Katona’s contribution

• Pointed out that an individual’s definition of saving differed from that of an economist - in particular drew distinction between discretionary and contractual saving

• Discretionary = an active decision to save during the current accounting period: Contractual = a decision made previously (e.g. to enter a pension plan that involves regular payments)

• Another useful distinction is between involuntary and voluntary saving - involuntary saving comes about when there is no active decision to save

• Katona noted that, year by year, people plan to save more than they actually do

Saving involves self-control - which is difficult!• Basic fact: animals and children (and some adults), when

given a choice between a reward that is available immediately and one that is available with some delay tend to choose the small immediate reward

• This preference is not, in itself, irrational - a number of factors make current consumption objectively more attractive than saving (death, risk of inflation, risk of default etc).

• But the extent of the preference defies rational analysis - normal adults say that they would prefer £5 now to £10 in two months - which could only be rational if the rate of inflation were several thousand percent

• So we combat this by developing techniques for self-control (e.g. pre-commitment, money-management techniques)

Saving and expectations about the future• People have a tendency to be over-optimistic in a wide

variety of domains (e.g. students over-estimate their post-graduation spending power). If this is true for expectations about future income, saving will be too low and borrowing too high

• BUT the very few studies that have been carried out (on Dutch households) suggest that people under-estimate their future incomes

• SO it may be better to think of people as using optimism (or pessimism) as a strategy, rather than being optimistic per se. Optimistic expectations about when one will finish a project may act as a motivator - pessimistic expectations about future income may lead to good money management

Thaler - the concept of mental accounts

• Thaler proposes that people have a number of mental accounts that operate independently of each other

• Money in different mental accounts is spent differently: propensity to spend is highest in the ‘current income MA’ and lowest in the ‘asset MA’

• This means that people may borrow to buy a car whilst they have savings - the bank will ensure that they repay the loan and this keeps their savings intact

• The idea of mental accounts, coupled with the notion that the individual is an organisation containing a far-sighted planner and a myopic doer, explains quite a lot of the financial behaviour seen.

Some recent studies • Debt - a panel study in the Netherlands

(Webley and Nyhus, 2001)

• Why do people save? - a study in the UK (Canova, Manganelli and Webley, 2002)

• Individual differences and saving (Daniels and Webley, 2000)

• Survey study of saving in UK and Italy (Webley and Burlando 2002)

Debt study• Steady stream of recent research on debt but it is very

static (only gives a snap-shot) and based on mail surveys with very low response rates

• Need to be clear about distinction between debt, default and borrowing.

• Borrowing is planned and intended (note that mortgages are not seen as debts but as savings by most people)

• Debt is an obligation that a person is unable or unwilling to discharge

• Default - simply not paying money owed

• Here focus is on debt

• Assume that there are two routes to debt (a) the personality route where relevant enduring dispositions (time orientation, lack of self-control), which have been fostered by particular parenting styles, lead people into debt (b) the rational route - if people experience what they see as a temporary drop in income, or a temporary increase in income, they may decide to run up (temporary) debts

• Used data from three waves of the CentER panel (from1994, 1995, 1996). This is a representative sample of the Dutch public. Individuals complete large numbers of questionnaires over computers so there is a vast amount of information available on them.

• Measure of debt was based on whether people were in arrears, had bank debt, reported being in debt, had numerous credit arrangements

Results• Descriptive findings same as previous studies - debtors

were younger, had lower income, rented accommodation, had more children, had less unfavourable attitudes towards debt

• Psychological variables add to our ability to predict debt. There are 7 predictors: Income, Age, No of children, Presence of partner, attitude to debt, obesity, use of money management techniques, self-control

• Many differences between never debtors and mild debtors:

• Debtors had more variation in income, higher 5-year income expectations, more income uncertainty, low life expectancy (the rational route) and were less conscientious and had less self-control (the personality route)

How far is debt a short term problem?

• Of the “stayers” (those in the panel for all 3 years), 66 were in debt in 1994. One-third stayed in debt for the next two

years, one-third have got out and stayed out of debt • Chronic debtors have lower incomes, less self-control,

shorter time horizons

• For 5 psychological variables looked at, the correlations between debt status in 1994 and psychological variables in 1996 were higher than psychological variables in 1994 and debt status in 1996. So differences in psychological variables may be a consequence rather than a cause of debt - e.g. obesity may be a result of comfort eating

Debt status in 1994 and 1995

1995

Non-debtors

Milddebtors

Debtors

Non-Debtors

1329 58 49

1994 MildDebtors

58 27 9

Debtors 56 15 49

Why do people save?• A total of 141 British adults answered a mail-questionnaire. 97

participants (69%) stated that they intended to save during the

next 12 months. • Those intending to save had to provide 4 reasons why they

wanted to save, then explain why these are important, and then

asked to give further justifications. • There were no significant differences between savers and non-

savers concerning sex, age, marital status, education, occupation, type of accommodation, dependant children, and source of

income. • Savers had a higher overall income than non-savers, were more

positive about the economic situation of the UK and are more

optimistic.

14 10 3 10 18,5 16 14 1,5 3,5 18## 0,81 0,67 0,67 0,63 0,56 0,4 0,35 0,3 0,29

Holidays /Hobbies

Purchases

Moneyavailabity

PrecautionRetirement

Old age /Illness

Speculation

Security

To avoiddebt

AutonomyHousehold

Self-esteemSelf-

gratification

10

6

11

6

58

6

7

5

67

5

10

16

15

7

6

5

9

20 86

5

26

Saving Goals• The placing of goals on the vertical axis follows the

relative ordering implied by the abstractness ratio. “Self-esteem” and “Self-gratification” are the highest-order goals; “Holidays / Hobbies” and “Purchases” are the lowest-order goals. Arrows go from goals that function as sources of motivation to goals that serve an intermediary or end-state objective.

• 3 general orientations can be discerned. One of these deals with ways of avoiding debt and of achieving a certain security in life. The second is reflected in the desire for self-gratification, which can be reached by means of holidays etc. The third focuses on old age. For these respondents, saving for retirement is important to guarantee gratification.. The 3 super-ordinate goals are also linked: security leading to autonomy, self-esteem and self-gratification are reciprocally connected.

Individual differences and saving

Purpose of this study is:

1. to explore the relationship between individual differences and saving

2. to look at the relative contribution of economic and psychological factors (do psychological factors improve our ability to predict saving?)

3. to look at the whether household saving behaviour is best explained using psychological data from both household members or just from the main decision maker

1. Questionnaires posted to 530 household (1060 individuals) in Exeter and Plymouth. Household selected from electoral register which comprised two individuals with same name and opposite gender [note: biases the sample towards conventional households] . Each member of couple asked to complete questionnaire

2. Completed questionnaires returned by 110 households (195 individuals)

3. Questionnaire covered

(i) demographic and economic variables (income, number of children, occupation, sex, age, housing)

(ii) psychological variables (impulsiveness, Consideration of Future Consequences scale, self-control, time preference, economic socialisation)

(iii) measures of saving (total household savings, regular saving)

Results

What IS the relationship between individual differences and saving?

1. The exact pattern of the relationship depends on whether one is looking at total or regular savings, and using data from just decision makers or both household members

2. time preferences, self-control etc all associated with saving in the expected direction (e.g. more impatient, less saving) except that higher impulsiveness was associated with more saving

3. Economic socialisation variables were not important - but

only measured with two very simple items.

DO psychological factors improve our ability to predict saving? YES

1. Hierarchical regression used with variables entered in order socio-economic, individual. diffs, economic socialisation

2. Total savings best predicted by age and time preference

3. Regular saving best predicted by financial situation, self-control, CFC scale, impatience

4. Note that this fits with Lunt and Livingstone findings that for total savings, socio-economic variables were more important and that for recurrent savings, psychological variables were more important

IS household saving behaviour best explained using data from both household members? YES1. There was a positive correlation between the scores of spouses

on most psychological variables (impulsiveness .45, CFC .24, delay of gratification, .36) though not all. Correlations were higher for those couples who had been married longer

2. Using psychological information from both couples improves our ability to predict both total savings and regular saving. Using only psychological variables, the R2 are

Total savings Amount saved regularly

Data from both spouses .32 .43

Data from decision maker .23 .29

Explaining cross-national differences in saving

1. There are very large differences in the savings rates across countries. Japan has a very high saving rate, Italy quite a high rate and the UK and USA relatively low rates. Why?

2. Economists’ attempts to explain these differences using economic indicators (growth rates, social security systems, tax incentives etc) have been largely unsuccessful

3. May they stem from cultural differences between countries? Carroll et al show that there are differences in immigrants saving behaviour by country of origin but that these do not match up with the differences in national savings rates.

Cross-national questionnaire study of savings

• Study tried to shed some light on the causes of the international differences in savings through a consideration of motivations for saving, income expectations, reference

group membership and trust in government. • Questionnaires covered all of these issues plus financial

planning. Five different measures of saving were used.

• Questionnaires distributed in Bristol, Exeter, Turin, Asti, n=347.

Cross-national differences in independent variables.

• Compared to those in the UK those in the Italian sample were (i) more inclined to want to save as much as possible (ii) had a longer time horizon (mode is 5-10 years for IT, next couple of years for UK), and (iii) found it easier to control their spending. Italians save more than UK sample (on all saving measures). The importance of different reasons for saving was similar though it is clear that medical care and children’s education are more important saving motives for the Italians and that saving for future consumption (e.g. holidays) is more important for the English.

• The preferred size of a buffer is much higher in the Italian sample (over £34,000, as opposed to a mean of £8,962 in the UK sample).

Results• The three psychological variables (time horizon, planning,

control) are all related to saving. So too was general trust in government (those who trust more save more), income, age and perceived financial status compared to reference group.

• To examine whether these relationships were independent, the data were analysed using multiple regression. A hierarchical form of analysis was used, which looked at the effects of a series of groups of variables in turn. The variables were entered into the analysis in the order; economic, demographic, social psychological, psychological. This analysis shows that whilst economic factors matter (a higher income leads to more saving), so too do social psychological and psychological factors. The impact of reference groups is particularly notable

• The best set of variables for predicting saving behaviour included income, housing, social comparison, self-control, planning and time horizon.

THE END

Unless you want some policy implications ...

Some policy implications• Saving is hard and getting into debt is easy. Policy needs to

be based on a firm understanding of why people save (and why they get into debt)

• Education matters. What evidence there is suggests that ‘learning to wait’ begins in childhood. So - from a long term perspective - we need to foster parenting and School practices that encourage saving

• The main reason for saving in the UK seems to be - ultimately - hedonistic (e.g. “to have the holiday of a lifetime”. People in the UK have trust in the government and still believe (unlike most Italians) that ‘the system’ (the state, their employee) will provide them with the pensions they are entitled to. So for Brits, saving for old age is well important. So one way - oddly- to encourage UK citizens to save would be to undermine their faith in the system.

Some policy implications (continued)

• Believing that you are financially better off than members of your reference group is a good predictor of saving. But most Brits (strangely) believe that they are worse off than people like them. This belief may be open to manipulation

• Those who have longer planning horizons save more (and are in debt less). Thinking more about the future is also something that can be encouraged

• There is probably value in disseminating good (simple and effective) money management techniques. Most people are surprisingly bad at managing money!