Behavioral Finance: The More We Make, the Better We Want

I actually got a chance this evening to read the New York Times Business section in careful detail, and I found this gem of a column by Robert H. Frank, economist at the Johnson School at Cornell University:

The More We Make, the Better We Want – New York Times

This is a wonderful piece, because it captures three things that I find equally fascinating in one, elegant piece:

  • Classical Economics can fail in prediction when it does not take into account the uniquely emotional relationship that people have with money. It’s funny in retrospect, but I remember reading about John Maynard Keynes prediction of productivity growth leading to a shorter and shorter work week, and an excess of leisure time. Like Lamarkian evolution, this type of economic thinking meets the initial “sniff test” for critical thinking, but because it gets the base mechanism wrong, fails in the critical scientific goal of not only explaining the past, but predicting the future. Outside of small enclaves in France and Marin, there are likely few who actually believe that increased productivity should lead to a shorter work week… but why? This is the first article that to me clearly articulated the concept that as productivity rises, so do incomes. And as incomes rise, an “insatiable demand” for increased quality follows. This is a behavioral finance insight in my book: an insight into the predictably emotional behavior of people and money.
  • Flaunting superiority is not the only reason people spend money on luxury goods. Living in the Silicon Valley, where people measure revenue per employee in the hundreds of thousands (and market capitalizations per employee in the millions), this insight is instantly recognizable. While it is of course true that people to some extent will spend money for status symbols and competition, this explanation does not really explain everything that people spend money on. This article ascribes this to pursuit of “increased quality”, which is a touch idealistic, but it still rings true. Do people spend thousands of dollars on computers and Plasma TVs just to have one “as good or better than others?” Possibly in some cases, but in many cases it is because people spend a lot of time with these goods, and they have the income to spend on making that time higher quality. What are the limits here? Are there any? If there really is no end to the consumption demands of individuals, that really validates some of the brightest and darkest theories about human happiness.
  • American vs. European Spending Patterns. When you look at the recent economic evolution of the major western economies, one of the striking divergences between Europe and the United States has been the balance between growth & productivity vs. stability & social welfare. After the malaise of the 1970s, the divergence becomes incredibly acute – the incredible growth of the United States, on top of an already incomparably large US economy has been astounding. I am personally skeptical of “purchasing power parity” methods for ranking international incomes for a large number of reasons. But leaving that topic aside, this article explains to me a lot of what I’ve personally experienced during my brief stay in France. You have many people, quite happy with a dorm-room sized refrigerator, a water heater the size of a waste basket, and a 19″ television. In the US, a similar person, in a similar economic decile (or lower), somehow has a 50 gallon water heater, a 25 cu. ft. refrigerator, and now probably a large, flat panel television. The easy answer is to say that all Americans are gross, disgusting over-consumers, who put all their value in material things. This article puts some basis behind an alternative explanation – higher productivity and incomes in the United States have allowed people increasing amounts of disposable income to spend on higher quality products & services. More importantly, that process is a never-ending cycle, leading to more productivity gains, and an ever-increasing standards bar for the quality of goods & services.

This seems like an incredible economic advantage, and it speaks to the recent incredible growth in the luxury goods market as a secular trend. Economies that continue to generate outsized productivity growth may in fact establish a powerful strategic moat based on their insight into the “next level” of quality in goods & services. That certainly seems to be part of what continues to happen on an ongoing basis in 21st century Silicon Valley.

One of the truly great aspects of economics is being able to read decades and centuries of theory – some of it incredibly insightful, some of it woefully wrong. The reason it is wonderful is because, unlike the hard sciences, economics is fundamentally a study of people – individuals, crowds, and their interactions. As a result, understanding the history of economics and the reasons why very intelligent economists ended up with the wrong predictions is incredibly edifying.

This is an article worth reading, and then letting it digest, and re-visiting again. I also find this line of thinking a portent of an upcoming golden age of economics, as ground-breaking for this area as Max Planck was for particle physics.

As a side note, I also learned that finding an article on the New York Times website is nearly impossible. I did a direct search for this title on Google, Yahoo, and on the NYT site itself, on the homepage and in the business section. No luck. It was only through some very intricate checkboxes and sub-filtering of the NYT search that I was able to find this article – I have the printed copy sitting right next to me!

You have to love the Internet – you can find everything that you didn’t know existed, and you can’t find the one thing you know exists and want.

4 thoughts on “Behavioral Finance: The More We Make, the Better We Want

  1. But Keynes’s prediction is closer to true in Europe — the American trade of more hours worked for more stuff isn’t the only option.

  2. In some ways, it’s true, but there is still a catch. The economies where this is closer to true in Europe are also some of the least competitive globally. If it turns out that there is strategic advantage to being closer to the “edge” of advancement in quality, then these countries will continue to find their competitiveness deteriorate in a competitive global environment.

    At this point, it seems like there are strong economic forces pushing back now on these economies which point back to longer hours and higher productivity.

    Thanks for reading & posting!

  3. great post adam…my sense though is that contrary to popular belief, “old europe” europeans are keenly aware of “quality” as referenced in the nyt article and willing to pay for it. i will elaborate a bit more on that later, but adam – i am reading a book that you must read next – “stumbling on happiness” by daniel gilbert. while i am only about a third into it right now, i think you will find it very insightful as it explores and inverts our very basic assumptions about human behavior, confidence about future, attempts to control it and the futility of the process as we strive for nirvana…would love to hear your thoughs on it soon.

  4. I tried twice to send you the response below to your earlier email, but both times my message was bounced back as undeliverable.

    Mr. Nash,
    Many thanks for your kind note, and for the nice comments about my column on your blog. At the risk of making you regret having requested pointers to other works on the same theme, I’ve attached a copy of my forthcoming book, Falling Behind: How Rising Inequality Harms the Middle Class.
    All best,
    Bob Frank

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