Irrational saving or rational spending?

One question economics prefer to avoid is why irrational solutions to common problems faced each day by individuals seem to work. For example, our lounge room clock is 20mins fast (yes, I know that’s a lot). But when chatting with my wife the other day about whether we should put it back to the real time we decided to keep it fast. For some reason if the clock says 8 o’clock, even though we know it’s 7.40, it seems later than it really is. I don’t know why, but it does.

Another classic example is saving. Economists assume that the savings rate is fixed by our preference for current consumption over future consumption (not only this, they assume that individual preferences are fixed over time – that’s right, from birth to death). To any person living in reality, this fixed assumption is obviously not true.

For example, there are literally millions of websites preaching new an innovative ways to implement a saving strategy. Freezing your credit card in a block of ice to overcome spending urges is one solution. Having your salary paid directly into a fixed term investment account that can’t be touched is another.

The intriguing question is why we can be rational enough to use these ideas, but not so rational as to not need them. I want to examine this point today.
Dan Ariely (one of the most interesting behavioural economists around) has a nice presentation about how people can change their behaviour to overcome our predictably irrational tendencies and act more rationally. For me there are two important findings of his work:

1. People can’t think properly about the opportunity cost of current spending. We have difficulty comparing $10 a week on coffee to a holiday in Thailand in two years time (which it could easily add up to be).

2. The simultaneity of paying and enjoying goods makes consumption less enjoyable. Paying far in advance or far later than the time of consumption makes paying far less painful. Seeing the ‘pain of paying’ when we make the consumption decision helps us save.

But Dan never really gets to the bottom of the problem. Even if we can objectively think about our consumption needs in advance, and follow Dan’s trick of using envelopes with our budget for each type of good for the month so when we pay for something we see our remaining balance decline (the pain of paying), what is to stop us simply using another envelope when the time comes to pay for something? After all, wasn’t that our problem in the first place?

Dan’s experiments are extremely insightful and may help some people to save. But I have a feeling that the majority of people who begin using these irrational saving tips fail to prevail in the long run. If this is the case, we can either assume that in the long run people a rational enough not to outsmart themselves or that saving itself is irrational.

I believe the second option is most likely – saving itself is irrational.

At the individual level there is no incentive to save. This is a classic example of the moral hazard of welfare. For example if you lose you job, or have some other unforeseeable downturn in the family finances, and you had been saving, you will have a large pool of capital which will disqualify you from welfare. If instead you spent everything you had and saved nothing, you would be supported by everyone else’s tax dollars. Like so many policies, our welfare system they reward those who contribute least (not that this alone is a reason not to have such systems in place).

We also have distorted incentives for saving, as compulsory superannuation has taken away much of the incentive for young people to voluntarily save for retirement.

The graph below is the household savings rate in Australia. Notice, the inverse relationship between the saving rate and periods of strong economic growth. It seems that when the going is good we don’t save, and when it is not so good, we save a lot more.

When the going is good there is less incentive to save, as financial pain from unforeseeable events is estimated to be temporary, while in the bad times, we become frightened of long term welfare dependence.
 
So where does that leave us on our tour of irrational saving. For the individual, it appears that our inability to save may in fact be our rational self striving to break through the social pressure to save. It also appears that when we really need to, we seem to have the ability to bite the bullet and through whatever ‘irrational’ techniques, save in a quite rational manner.