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Wednesday, 7 December 2011

Get Rich, Flee Temptation

Double Your Salary

Let’s say you were made an offer in return for giving up your favourite treat for a month: let’s say you were told you would double your monthly salary – forever – if you abstain from alcohol or coffee or heroin or whatever for just four weeks. Would you take this deal?

It’s a no-brainer, of course, which is why it’s exceedingly odd to discover that this exact deal is one that many of us are unable to make. Human lack of self control is a remarkable thing, but it’s made many times worse by financial services offers designed to lead us into temptation.

No Self-Control

Some innovative research on fruit sellers in India has shown that the astonishing bargain being offered above is one that only around 30% of these people can make. In Micro-entrepreneurs and their Money Bindu Ananth, Dean Karlan and Sendhil Mullainathan state:
“Consider the case of a vegetable vendor in Chennai: Nearly every morning, she takes out loans to buy vegetables from a wholesaler, and in the afternoon she pays the loan off with her daily sales. She does this every day, paying an interest rate of 10% per day. Fruit vendors, flower vendors, and other vendors of perishable products take out similar high interest, short-term loans to finance their working capital.”
Yet if these people saved only 1% of the working capital that they’re borrowing they would be debt free and double their profits in 28 days : which is the equivalent of foregoing two cups of tea a day. This is the power of compound interest. It’s crazy to borrow at 10% a day when you don’t need to – in fact, failing to make this decision virtually ensures a state of  perpetual poverty.

Marginal Existence

This research may not seem immediately relevant to the lives of wealthy, first world citizens, but it’s immensely revealing because it shows that, even at the margin of existence, human levels of self-control are poor.  In less obviously distressed conditions one doesn’t have to think too hard to see what the effects of this might be.

Clearly, there could be multiple factors explaining this behaviour, including the possibility that people don’t understand the maths behind compounding. However, those problems aren’t confined to poor fruit sellers; as we’ve seen, in numerous pieces of research, low standards of financial numeracy are endemic across the world (see Financial Education Doesn't WorkFreedom of Financial Choice Is A Myth and Intelligence Can Seriously Damage Your Wealth). Moreover, even if people do understand the problems it’s not entirely clear that they can stop themselves consuming what Abhijit Banergee and Mullainathan describe as temptation goods:
“In our framework, the donut or the cigarette represents a temptation good. In the moment we would spend money on it. But we would like future selves to not spend money on it. Temptation goods give us utility in the moment but it is not utility we care for when considering future selves. This is in alternative to other goods where present and future selves agree: in the moment we spend on them and we would like future selves to spend on them as well. These are goods like a good education for our child, our a nice house to retire in.”
Proportional Myopia

The main point for the researchers is that the richer you are the smaller the proportion of your income you spend on temptation goods, and that temptation goods are what drives the myopic behaviour which prevents the poor from climbing out of the hole that they’re in. However, while this is a plausible explanation of why many of the poor stay poor, it seems like it might be an equally applicable explanation of why the indebted of wealthy nations also stay in debt – all we have to do is replace "donut" with "High Definition television"  and “cigarette” with “luxury vacation” in the quote above.

Of course we can be sanctimonious about poor people spending money on wine or cigarettes while their children lack mosquito nets or basic education, but that’s a pretty easy call to make when you live in an air-conditioned condo and benefit from state sponsored schools. Yet the lack of self-control of first world consumers isn’t any better than that of the third-world, and is a darn sight more damaging to the world economy and our children's combined futures.

As the researchers above argue, part of the problem is in the design of financial systems which don’t take account of the self-control issues and myopia for future outcomes associated with temptation spending. Offering mechanisms to allow people to engage in mental accounting – separating out funds to make it easier to exercise self-control – is a basic premise, and it’s one we’ve seen encouraged by adherents of nudge techniques in both the USA and the UK.

Adverse Adverse Selection

Sendhil Mullainathan (yep, him again) along with one of the advocates of nudge approaches, Richard Thaler, and Emir Kamenica has recently published a paper on how consumers can get some control over their lives in our increasingly complex world. In Helping Consumers Know Themselves they argue that, increasingly, corporations know more about our behaviour than we do:
“In the health insurance market, for example, customers are typically assumed to know more about their health status than insurers do, and if the customers use this information in deciding whether to buy insurance, we have a classic case of adverse selection. Modern data-gathering technologies, however, can reverse this situation. For example, because cell-phone providers keep and analyze detailed records, they can know more about a consumer’s expected usage than the customer herself does. Similarly, a credit card company may know more about a customer’s probability of incurring a late fee than the customer herself “.
As we saw in The Secret of a Healthy, Wealthy Life many organisations are extremely good at using our lack of self control to extract money from us. The advent of data-gathering and social networking has the possibility to accelerate this. If a professional person loses their job today what’s the first thing they do? Well, after having a few beers they'll most likely go onto LinkedIn and announce to their connections that they’re looking for a job. Now that’s really interesting information to that person’s mortgage supplier and credit card issuer: and if you think that kind of analysis isn’t already taking place then think again.

Transparency or Bust

The researchers argue that consumers have a right to the information that companies collect about them, so that they can use it to make informed decisions about their own behaviour – with the hope that cloud based businesses can also use this information to force competition and openness. Applied to the price dispersion problem of the financial service industry – where it’s almost impossible to compare offers because they’re all deliberately different – and the problem of people discounting future costs in favour of the best up front deal on credit cards, this might make some difference.

However, while making this information more transparent is a good thing it isn’t entirely obvious how this will stop people being tempted into paying for things they don’t really need on the never-never at the cost of a debt-laden future. Unfortunately many previously profligate governments are now trying to encourage people to consume rather than to save, in order to drag economies up out of the dust. Sadly if we all start to behave in a responsible financial fashion we all lose out.

Still, at least the myopia problems of the indebted middle classes of the first world don’t mean that our children are dying for want of our self-control. But we shouldn’t think it’s because we’re better people, it’s not, it’s an accident of birth: temptation rules us all.

Related articles: Finance: Where The Law of One Price Doesn't ApplyPutting Down The Credit Cards, Economic ParasitesFinancial Education Doesn't WorkFreedom of Financial Choice Is A MythIntelligence Can Seriously Damage Your Wealth

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