Why we can't stop spending (Part III)

The dangerous paradox: Policy-makers have encouraged Canadians to keep spending, while decrying rising debt levels.

(Part three of a four-part series. For part two, ” Sub-optimal behavior,” click here.)

Mixed messages

One effective coping strategy for dealing with the challenge of overspending is making commitments. People can join pension plans or sign up for automatic deposits into their savings account; in both cases, they begin saving automatically. Even a mortgage is in one sense a commitment strategy, because it forces monthly payments that result in increasing equity over time. But David Laibson, a Harvard economics professor and prominent behavioural theorist, suggests credit innovations in recent decades undermined such tactics. The proliferation of credit cards and lines of credit, which can be accessed immediately, allow us to simultaneously save while racking up debt as never before. Laibson suggests their rising popularity contributed significantly to falling American savings rates, and it likely applies here as well.

Our competitive nature also betrays us. Homo economicus is happy after buying a new 42-inch LCD television; real people are often disappointed when they glimpse their neighbour’s 52-incher. Back in 1949, an American economist named James Duesenberry penned a classic essay examining the ‘keeping up with the Joneses’ phenomenon. Back then this competition was largely confined to neighbourhoods — that is, among people of similar incomes. Americans saw their neighbours’ Fords and General Electric refrigerators, coveted them, and often purchased similar models.

What’s new is how people make those comparisons. Seeking to explain American spending patterns more than a decade ago, economics professor Juliet Schor (now teaching at Boston College) believed members of the middle class were no longer competing only against their neighbours. Rather, they’d begun comparing themselves to people earning three, four, even fives times their salary. This transition was amplified by fictional television shows, which present a higher proportion of high-income characters than found in the actual population. The result: a growing mismatch between median incomes and aspirations.

‘The new consumerism has led to a kind of mass over-spending within the middle class,’ she claimed in her 1999 book, The Overspent American. ‘Large numbers of Americans spend more than they say they would like to, and more than they have. They spend more than they realize they are spending, and more than is fiscally prudent.’ Sound familiar?

Retailers, marketers and financial institutions can use these tendencies and weaknesses against us. But when even our government gets in on the action, the results can be frightening.

Should I stay or should I go?

It was a Hugo Boss and Anne Klein crowd. At $79 a head, they crowded a cavernous underground ballroom at Toronto’s Sheraton Centre to hear Mark Carney, governor of the Bank of Canada, deliver his latest warning to the Economic Club of Canada over lunch. ‘The proportion of households with stretched financial positions has grown significantly,’ Carney admonished. And that will continue, absent ‘a significant change in behaviour,’ he added sagely.

There’s more than a whiff of hypocrisy here. For Carney is really telling Canadians to spend like drunken sailors. Not using those terms, of course. But he controls the overnight rate, the interest rate at which financial institutions borrow and lend one-day funds among themselves. During the recession, he lowered it as low as it could go, which drove down the rates paid by savings accounts.

It also cheapens borrowing costs, helping banks offer cheap mortgages and lines of credit — an overwhelming impetus to borrow and spend. Meanwhile, his colleagues at the Department of Finance provided their own incentives, such as tax credits that encouraged Canadians to renovate their homes.

All this had the desired effect. Statistics Canada reports that spending on home repairs and maintenance increased 22% in 2009 over the previous year, ‘likely due to the federal government home renovation tax credit program.’ (The federal government says it caused an additional $4.3 billion, or about $125 per citizen, to be spent on renovations.) During an October 2009 speech, Carney himself celebrated that consumers got their ‘mojo’ back. ‘Consumer demand is going to be at the heart of this recovery,’ he told a news conference. More recently, in January Carney maintained the overnight rate at a rock-bottom 1%.

Such tactics are understandable. The so-called paradox of thrift, popularized by famed Depression-era economist John Maynard Keynes, holds that during serious economic downturns it may be in each individual’s interests to save money and repair his personal balance sheet. But if everyone does that, aggregate demand plummets. Companies’ sales fall, and they respond by slashing salaries or laying off workers. Total savings actually decline while the economy is laid waste.

Nobody wants that, which is why policy-makers continue to encourage people to keep spending. ‘They are trying to manufacture a soft landing and avoid a Depression, which is a good thing,’ says Hendren. The Bank of Canada reasons that Canadian households were well-positioned to spend more; after all, they were then saving more than Americans and were carrying less debt.

We’re now seeing the consequences. Late last year, economists at CIBC said rising household debt was to be expected; Canadians ‘responded rationally to an era of very low interest rates.’ Chalk one up for Homo economicus. However we regard consumers — as sober actors or hapless puppets — we can see that federal policy in recent years has been particularly dangerous. Incentives like low interest rates appeal simultaneously to our rational and irrational selves, leading us very much into temptation.

Tomorrow, in part four of our four-part series “Why we can’t stop spending,” we look at what the end of our spending orgy is going to look like and what might trigger it.