Blogs | October 11, 2010

Why do we save and spend?

What determines how much we save and spend? This question was sparked by a quote from a Bank of England official.

In a thought that might have been shared by many central bankers around the world at that and later times, Bank of England deputy governor Charles Bean was reported in 2010 as saying: “In the short term we want to see households not saving more, but spending more.” So what actually makes us save, or spend more?

We decide when to spend
Conventional economics says our spending decisions are determined by our wealth, incomes, interest rates and future prospects. We don't change our spending just because a nice man asks us. Was Bean wasting his breath? Maybe not. The conventional view is incomplete: our spending also depends on our culture.

But our culture plays a role too – just ask the Swiss
One simple fact tells us that culture is a factor. In the last 15 years the Germans, Belgians and Swiss have saved an average of more than 10% of their post-tax incomes – twice as much as Americans, Canadians and Australians. It's hard to attribute such differences to differences in wealth or interest rates. There are two mechanisms through which a spending (or saving) culture can emerge.

Once we start, it's hard to stop
One is our tendency to emulate others' spending – to keep up with the Jones'. Robert Frank of Cornell University showed in his book, Luxury Fever, how Americans in the 00s spent more and more on big cars and luxuries in order to keep up appearances with their high-spending peers. It's not just Americans that do this. A recent study has found that when a Dutch person wins a new BMW in the country's postcode lottery, the winner's neighbours are subsequently more likely to buy new cars themselves.

The second mechanism is force of habit. Our spending this year is more closely linked to our spending last year than conventional theory predicts. Once we acquire tastes for fast cars, fine wines and designer clothes, it's hard to shake them off. These two mechanisms suggest that low spending can feed on itself. If our neighbours' cars are getting shabbier, we'll be less inclined to buy a new one. And if we get into the habit of avoiding fancy restaurants or expensive boutiques, we'll stay in the habit. A temporary downturn might therefore become a long-lasting one.

Enter the Bank of England's professor Bean. In urging people to spend, he was trying to nudge people – to use Richard Thaler and Cass Sunstein's term – out of a low-spending path and onto a higher-spending one. Of course, most people will ignore him. But even if only one person in a thousand goes out and spends more, they will influence their friends and neighbours to do so too. Bean's problem was that perhaps not even one person (beyond the writer of this blog post, of course) was listening.

How to balance spending and saving
There is, though, a message in this for all of us. Financial advisors are forever telling us how to save and invest, but in fact the most important influence upon our future wealth is not how we save, but how much. And if this decision is swayed by our neighbours or our past, we can fall into a trap of saving too little (or too much (few people on their deathbeds wish they had saved more). In this sense, what matters is not just financial planning, but character planning. And this requires us to be aware of the influences on our decisions.

SpendingEconomicsSavingPersonal financeSociety

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist