Friday, 19 June 2009

Krugman and macroeconomics: an explanation

I'm on a continuous quest to apply behavioural modelling to macroeconomics, and I have some way to go before I complete a model that is credible, tractable and predictive.

But what I can do is use behavioural finance research to explain a trait that Paul Krugman discusses in his blog posting today.

Put simply, people feel losses much more keenly than they imagine gains.

Ask a hundred people whether they'd work an hour to earn £10 and most of them will say no. But overcharge them £10 on their mobile phone bill and watch them sit on hold, fill out forms and argue with shop assistants for as long as it takes to get their money back.

And there is something about fiscal deficits that just feels like a loss. Carrying billions of pounds of debt and knowing that your income tax will go up to pay for it is a very concrete concern. But the idea that without it, you will lose 10% of potential growth in your income, is much harder to get worked up about.

You could make a legitimate argument that the debts are (relatively) certain while the benefits are not guaranteed. But to counter that, there are ways to reduce the effective costs of a stimulus - Krugman has pointed out that about 40% of it comes straight back in tax anyway, and there's always inflation (at least, there was always inflation, and will be again). The overall consensus of economists is that the risk-weighted benefits exceed the costs.

But a reasoned argument like that has much less impact on the gut than the idea that politicians are gambling with your money, running up a £20,000 debt which you will have to pay off, paycheque by painful paycheque, with the sweat off your back.

Psychologically I ascribe this to the following cognitive process: we have a stronger visualisation of situations that we're familiar with than those we haven't seen before. Thus, when you have suffered a loss, you are in one state-of-the-world comparing it with a state you are already familliar with - the one before the loss - and you can easily compare the two and feel the difference. But when contemplating a potential gain, you are comparing the current state-of-the-world with a provisional one you have never experienced. This is much more difficult.

Or look at it this way: most of us can remember what it was like to be poorer - but few of us have been richer than we are now. And so it's painful to imagine going back, but not equally powerful to imagine going forward.

So losses - and by association, debt and higher taxes - have a powerful hold over us. That's why it's only by evoking the Great Depression that economists and politicians have pushed through the stimulus packages that have happened so far.

The cultural expression of this is that those who play safe, consume little, don't borrow, and save for the future tend to be admired over those who take risks and borrow to consume or invest. But as I said in a previous post, for one person to save, another has to borrow; for one to sell, another has to buy. Economics is fundamentally about trade-offs, and different preferences giving rise to mutually beneficial situations. And similarly, a preference for saving and accumulation is appropriate at some times, and a preference for borrowing and running down the reserves is appropriate at others. Now is the time for borrowing.

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