the psychology of the current crisis

The psychology of the current crisis

Stephen LeaPsychology

University of Exeter, UK

23rd August 2010 Stephen Lea: ICABEEP Summer School, Moscow

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Structure of the talk1. Introduction to economic

psychology2. Money psychology and the

recession3. Debt psychology and the

recession4. Macroeconomic psychology, or

what should we do next?


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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...


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The UK Economic and Social Research Council’s 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


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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 people’s 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 we’ve been here before: Katona & Strumpel (1978)


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The evidential base• So, I’m 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)


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The basic psychological / behavioural position on the economy

• Contrary to the foundational assumptions of 20th 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


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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...


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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


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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?


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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


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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 don’t understand the basis for their trust. Trust is a psychological and phenomenon, and it is at risk in recessions and other economic crises.


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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


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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


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Money psychology and the recession

• Money illusion has probably been important in people’s 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


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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


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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)


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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...


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Coping strategies of poor debtorsTypical 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 children’s 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


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Debt psychology and the recessionAnecdotal/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?


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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?


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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”


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1. 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).


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2. 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 haven’t)


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3. The affordable loan• People find interest rate calculations difficult, and

don’t 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...


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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 accountThis is what needs to be dismantled


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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 people’s wishes, their incompletely informed judgements and sometimes misinformed feelings are always part of the story


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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


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The spreading effects of recession


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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


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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


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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


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Is any of this being done?

No


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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 people’s 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-1990

experience of what was once the Soviet bloc, it would not have taken a recession to make this clear


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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”


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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, 291-297.• Diaz-Serrano, L. (2009). Disentangling the housing satisfaction puzzle: Does homeownership really matter? Journal of Economic Psychology, 30, 745-755.• 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, 153-172.• 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.

139-143. 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, 161-

209.• Lea, S. E. G., Webley, P., & Levine, R. M (1993). The economic psychology of consumer debt. Journal of Economic Psychology, 14, 85-119.• 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, 681-701.• Loewenstein, G (1996). Out of control: Visceral influences on economic behavior. Organizational Behavior and Human Performance, 65, 272-292.• 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, 449-467.• Ranyard, R., Hinkley, L., Williamson, J., & McHugh, S (2006). The role of mental accounting in consumer credit decision processes. Journal of Economic

Psychology, 27, 571-588.• Richins, M. L., & Dawson, S (1992). A consumer values orientation for materialism and its measurement - scale development and validation. Journal of

Consumer Research, 19, 303-316.• 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, 341-374.• Shefrin, H. M., & Thaler, R. H (1988). The behavioral life-cycle hypothesis. Economic Inquiry, 26, 609-643.• 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), 195-206.• 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, 1124-1131.• 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, 65-76.• Webley, P., Lea, S. E. G., & Portalska, R. (1983). The unacceptability of money as a gift. Journal of Economic Psychology, 4, 223-238.• Zelizer, V. A. (2000). The purchase of intimacy. Law and Social Inquiry, 15, 817-848.

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