ECONOMICS used to concern itself with a species called Homo economicus 鈥� a purely rational being driven largely by self-interest. In this Panglossian world, everything worked out for the best if you just left it alone. Sadly, real economic life doesn鈥檛 work like that.
Research into the psychology of economic behaviour has shown that, contrary to the assumptions of 20th-century theoretical economics, it is not completely described by rational choice models. The deviations from rationality are substantial and systematic. It follows that an economics, or an economic policy, that does not take psychology into account is radically incomplete.
So what can economic psychology say about the recession and the recovery? It is clear that the current situation was brought about by a crisis in the use of credit. Credit always requires a willing lender, and economists have documented how feckless bankers and complacent regulators lent and allowed lending where they should not.
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There are plausible psychological explanations for that. However, I am concerned not with lenders but borrowers. No loan can take place without both, so at least half of the psychology of the credit crisis is the psychology of borrowers 鈥� and that means the psychology of you and me.
I think that three of the best-documented tenets of economic psychology can help explain why we collectively took on the loans that events have proved were so unwise.
The first is materialism. In general, the link between wealth and happiness is less strong than you might think, but there are some people who strongly believe that owning more things will enhance their happiness. Such people tend to be less happy than others 鈥� they are always on the hunt for more possessions. In countries like the UK, where house ownership is deemed especially desirable, these people will drive demand, and hence house prices, above any rational level.
鈥淪ome people believe that owning more will make them happy. They tend to be less happy than others鈥�
The second is money. Often thought of as simply a convenient tool for facilitating transactions, it can be argued that, psychologically, money is like a drug, giving pleasure and being sought for its own sake as well as for what it can purchase. One aspect of its drug-like properties is the money illusion: people feel they are better off if the price of their house has doubled, even though, if all house prices have doubled, and they still need somewhere to live, their real wealth is unchanged at exactly one house.
Finally, we have the most spectacular deviation from rationality: the massive myopia with which we approach choices between good things that will arrive at different points in the future. Humans are quite hopeless at such 鈥渋nter-temporal choice鈥�, consistently choosing to take small benefits sooner rather than large benefits later.
Put these responses together and we have at least a plausible explanation of why so many people were willing to take on the unwise loans that the bankers offered them. So can this interpretation of the past shine any light on the future? Has psychology anything to say about recovery from recession?
John Maynard Keynes pointed out the paradox of recession economics: in the long run, people need to save more and borrow less to prevent the crisis recurring. But in the short term, if we all do that, the recession will deepen into a depression.
A psychologically sophisticated recovery policy would focus attention on what George Katona, one of the founders of economic psychology, called the 鈥渂etter-better鈥� group: people who feel they are better off than they were a year ago, and who believe they will be even better off in a year鈥檚 time. Katona showed that their behaviour was the motor of economic recovery. It is the better-betters who are most likely to spend the economy back to stability.
Where are we going to find them in the present climate? The answer is that the great majority of people are not directly affected by the crisis. A recession makes us all less well off on average, but its impact is very unevenly distributed. Some people suffer major effects, losing their jobs or their businesses. But the majority of us suffer only marginal effects 鈥� a small increase in taxation, perhaps 鈥� and some are virtually immune, including many pensioners.
However, a much larger number of us are affected indirectly, either by the fear that we will be among those hit by the recession or through its effects on friends and family. We are all influenced by the 鈥渞ecession atmosphere鈥� created by the media and policy-makers, with the result that people who are objectively unaffected nonetheless make cautious, conservative economic decisions. People whose circumstances place them in the better-better group nevertheless do not feel part of it.
What we need to do is build realistic confidence among those who can afford to act confidently. There is no economy without psychology, so there can be no economic recovery without psychological recovery. Economic policy needs to encourage people to recognise that they are in the better-better group.
It also needs to give a steer to the way they spend. Recovery will be faster if they spend money on products that have a high multiplier effect 鈥� in other words, they keep money in the economy where it will be spent again. That means spending it on services rather than goods, and spending it disproportionately with those of lower income.
In a recession, economic psychology endorses Hilaire Belloc鈥檚 dictum: 鈥淚t is the business of the wealthy man to give employment to the artisan.鈥�
