How Not to Pay Your Debts

An article by Amar et al [1]. showed how irrational people can be when it comes to paying one’s debts. The experiment setting (or one of them) was simple enough:

You have a two debts with different balances and different interest rates. You need to make a decision how do distribute a given amount of cash to pay back some of those debts. 

For example, let’s suppose you have these two debts:

Debt A: Balance 100 €               interest rate 5 %
Debt B: Balance 1000 €             interest rate 10 %

You get 100 € of cash. How do you allocate the money to paying back those debts (assuming you must spend all of it on paying back the debts)?

How would you?

[scroll down for result]

Suprisingly enough, the experiment shows that 29 % of people actually used the 100 € to pay back debt A! Mathematically, this obviously makes no sense. People should pay back debt B. Let’s look at the numbers:

Pay back A				Pay back 100 € of B
Debt	Amount left	Accrued interest		Debt	Amount left	Accrued interest
A	0 €	0 €		A	100 €	5 €
B	1 000 €	100 €		B	900 €	90 €
total	1 000 €	100 €			1 000 €	95 €

So here’s yet another example of how we manage to be very irrational even in cases where the numbers are concrete and easy to calculate. But, thankfully this is one of those problems that can be solved: according to the study, whereas a significant majority of normal consumers paid debts in the above situation unoptimally, only 21 % of financial professionals made the same error. They had learnt to obey the heuristic rule “always pay back the debt with the highest interest rate”.

[1]

Amar, Moty, Dan Ariely, Shahar Ayal, Cynthia E Cryder, and Scott I Rick. “Winning the Battle but Losing the War: The Psychology of Debt Management.” Journal of Marketing Research (JMR) 48: S38–S50.

The Psychology of Debt and Materialism

Debt crisis, debt bomb, financial crisis – you’ve heard it everywhere. And it’s still going on. The European debt crisis may not make the headlines every night (seriously, the viewers can’t take it anymore) but the crisis is far from over. Blaming it on the spendthrifts of Acropolis may seem like a neat idea, but admittedly our Hellenic cousins are not the only ones who have been on a finance-fuelled spending spree.

Carmen Reinhardt, a University of Maryland economist, and Harvard professor Kenneth Rogoff published a book called This Time It's Different: Eight Centuries of Financial Folly three years ago. They report that 90% public debt-to-GDP ratio is a so-called critical threshold, beyond which problems are of the worrying scale[1].

Consumerism is a fundamentally materialist social order, holding buying and consumption as the most important ways of action in society. Whether you like it or not, we live in a consumerist society at the moment. Interestingly, both consumption, use of resources and debt levels have risen considerably in the last decade (see graphs).

source: http://en.wikipedia.org/wiki/File:World_GDP_Per_Capita_1500_to_2000,_Log_Scale.png

As interesting as this is economically, a more important question in my opinion is why are we so indebted? What makes the debt rack up so fast?

In economic psychology, it has long been thought that materialism may well be connected to increased debt on a personal level. In this context materialism is a psychological stance, mainly meaning that a materialist person places a lot of value on things and possessing them. Usually studies differentiate between subjects with high and low materialism.

Is the connection of materialism and debt proven? In a study[2] Watson showed that materialism is correlated with laxer attitudes toward debt. In another study[3], Richins showed a connection between materialism and behaviors linked to credit overuse. So, the evidence is convincing in the way that materialism probably can be linked to higher debt levels, at least to some extent.

Quite frankly, linking this with the racking up of public debt is just an idea – it has never been proven (or even researched, to my knowledge). But there’s still a very important interplay of society and the individual here: namely, the process of acquiring a materialist psychological stance in the first place.

As with any belief system, there are two ways we can acquire materialism: either it’s in the genes or we have learned it through society. I can’t see the genetic argument really working for materialism. The world of our ancestors was hardly very focused on items, and hence “genetic materialism” seems to have very little face validity. Therefore, the only sensible conclusion is that we have learned the belief. And that is exactly the link that could justify the connection to global debt.

What if our global debt is also influenced by the same materialist beliefs? What if that’s why the system tries to get more than it can afford? And, more importantly, what will happen once we figure out we’ll never pay back our public debt?

Interesting, and scary, indeed.

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[1] http://www.forbes.com/forbes/2010/0208/debt-recession-worldwide-finances-global-debt-bomb.html

[2] Watson, John J. “Materialism and Debt: A Study of Current Attitudes and Behaviors.” Advances in Consumer Research 25, no. 1 (January 1998): 203–207.

[3] Richins, Marsha L. “Materialism, Transformation Expectations, and Spending: Implications for Credit Use.” Journal of Public Policy & Marketing 30, no. 2 (Fall 2011): 141–156.