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Purse Strings of the Heart

September-October 2001

Odysseus struggled to resist the Sirens. Adam Smith warned of dangerous passions for profusion. And we have all, despite our diets, succumbed to that beckoning slice of pie. The desire for instant gratification can run roughshod over our best intentions. Finally, contemporary economists are catching on. After centuries of basing their assumptions on the premise that people act rationally, they are now acknowledging that psychological variables like self-control (or lack thereof) profoundly influence economic behavior.

"Economists had looked for the simplest model, purged of the psychological stuff. That was considered auxiliary," says Sack associate professor of political economy David I. Laibson '88. Now the burgeoning discipline of "behavioral economics" brings emotional factors into economic models. In Laibson's hands, this behavioral approach outdoes traditional models--especially when accounting for apparently irrational phenomena among consumers like debilitating credit-card debt.

The traditional economic model, extrapolating from the rational "economic man," predicts an average household debt of $900. In fact, according to Federal Reserve data, the average American household owes $4,600 on credit cards, often at interest rates of 18 percent or even higher. Meanwhile, many of the same people hold investments earning well under 10 percent. While they may have logical reasons for their behavior, it seems irrational. But to Laibson, credit-card borrowing is no surprise. His behavioral model, which applies "hyperbolic discounting," expects a debt of $3,408.

Laibson has advanced the theory of hyperbolic discounting in a recent series of papers. In a simple illustration, most of us prefer one apple today over two apples tomorrow. But at some point on the time horizon, our preferences reverse: people prefer two apples in 100 days to one apple in 99 days. The difference in one apple's value between today and tomorrow is much greater than the difference between waiting 99 days and waiting a hundred. Hyperbolic discounting means that our discount rates (the values we personally assign to an object like an apple) do not remain constant, but are greater in the short run than the long run. Hence consumers are willing to pay exorbitant interest rates on credit-card debt while earning much smaller returns on long-run illiquid investments.

In his credit-card research, Laibson did not directly confront consumers about their spending habits, but rather constructed mathematical formulas that could reasonably approximate existing empirical data. His formulas simulate consumer spending and saving patterns; Laibson tries to create the best match between the simulated data and reality. Unlike traditional models, Laibson's formulas include variables for credit-card debt, changing household size, and illiquid assets. But the most striking difference is the assumption of hyperbolic discounting. By factoring in a discount rate that declines at different rates over time, Laibson captures the self-control problem in mathematical form.

Laibson's research grows out of a seminal 1956 article by Robert H. Strotz, the revered bellwether of behavioral economics. Strotz's observations on myopia (the inconsistencies between our short- and long-run behavior) inspired Laibson to consider consumers' breakdowns of self-control. Traditional economics, for example, postulates that future intentions accurately predict future behavior: if we plan to save $1,000 by December, we will save $1,000 by December. But while intending to save, we simultaneously crave instant gratification--and achieve this by spending our income now. When the "future" becomes the present, our cravings rule.

"We plan to cut back on sweets tomorrow," Laibson says, "and then tomorrow we're given a slice of chocolate cake and we say, 'Well, just this one piece'"--so we revise our plan and decide to start the following day. This drive for instant gratification, he says, entices households to spend their cash (or liquid wealth), as well as to borrow aggressively on credit cards.

Although consumers like to spend in the short run, they also strive to build illiquid wealth, such as investments in homes and 401(k) programs which provide substantial long-run returns. "We find that households are patient in the long run, and impatient in the short run," Laibson says. "They are dynamically inconsistent."

This notion of conflicting preferences--choosing to act both patiently and impatiently--challenges traditional economics, which posits unified, consistent preferences and assumes that psychological factors are too complex to formalize into models. But Laibson argues that consumers are complicated, and that purely rational models overlook basic elements of behavior in the marketplace. In his research, he assumes that people are sophisticated enough to acknowledge their inconsistencies. "Consumers correctly predict that later selves will not honor the preference of early selves," he argues. Consequently, people adopt various strategies to save for the future. By investing heavily in assets that are difficult and costly to sell, such as homes, consumers tie up their money to forestall splurging. Illiquid assets are bulwarks against eroding will power; they are commitment devices, like scheduling a 9 a.m. appointment to keep from sleeping late--Laibson's personal technique.

"We'll never achieve a perfect model. That would be the world itself," Laibson says. "But we can build richer and richer systems to make better and better approximations of reality."

~Catherine Dupree

David Laibson e-mail address: [email protected]

David Laibson website: http://post.economics.harvard.edu/faculty/laibson/laibson.html