Real (inflation expectation adjusted) market interest rates, I assume, are continually converging toward a stable time preference, though we cannot be sure because time preference is rarely directly visible.
BOX 1.1: TIME PREFERENCE AND SAVINGS
The extent that we discount the future (time preference) must obviously affect our saving propensity. A high preference for immediate consumption would diminish the propensity to save while a high preference for saving for retirement, for example, would diminish the propensity to consume. But through most of history, time preference could not have had a major determining role in the level of savings. Prior to the late nineteenth century, almost all production had to be dedicated to keeping the population alive. There was little to save even if our inbred propensities were inclined in that direction.
Western Europe’s population, for example, was able to grow only 0.2 percent annually between 1000 and 1820, following stagnation in the previous millennium.* It is only when innovation and productivity growth freed generations from the grip of chronic starvation that time preference could emerge as a significant economic force. Since 1880, the gross private savings rate in the United States has been remarkably stable, ranging mostly between 10 and 20 percent of GDP. Gross domestic savings averaged somewhat higher, and as can be seen from Exhibit 9.5, the savings rate rose sharply after 1834.
Savings is a measure of the extent of abstaining from consumption. Investment is a measure of the particular assets to which those savings are applied. Savings and investment, as I note in Box 9.3, are alternate measures of the same transactions, ex post.
Culture reflects a country’s degree of abstinence. People acting rationally would tend to save in their early years to create provisions for years of retirement. (“Retirement,” incidentally, is only a twentieth-century phenomenon.) But our less rational propensities are too often evident in a failure to always do so.
What is remarkable is how, in the United States, we have managed to exhibit so stable a private savings rate for more than a century. Time preference, judging from the historical data on the long stability of real riskless interest rates, apparently remained stable, and doubtless sets the upper limits to the proportion of income that people are willing to save, if they are able to do so at all. It has only been when human ingenuity brought production levels beyond the needs of raw survival that time preference became a factor in the rate of savings.
Herd Behavior
There is a universally observed human trait to follow or emulate a leader of some sort. It is driven by most people’s need to achieve the security (emotional and physical) of belonging to a group. It is arguably one of our most important propensities, second only to fear, and a significant driver of economic activity. Herd behavior exaggerates speculation and the business cycle as it distracts us from the facts of markets and draws us to the less relevant views of other people. It captures consumer behavior known by the idiom “keeping up with the Joneses,” also known as “conspicuous consumption,” the term coined by Thorstein Veblen in 1899.7, 8
I would argue that this behavior accounts for the long-term stability we see in household spending and saving patterns from one generation to the next. Personal savings as a share of disposable personal income during peacetime has held in a relatively narrow range of 5 percent to 10 percent almost all of the time since 1897 (see Exhibit 1.1). With the very large rise in average real household incomes over the generations, why does the average savings rate not rise as a consequence? As I noted in The Age of Turbulence (pages 269–70), happiness depends far more on how people’s incomes compare with those of their perceived peers, or even those of their role models, than how they are doing in any absolute material sense. When graduate students at Harvard were asked awhile back whether they would be happier with $50,000 a year if their peers earned half that, or $100,000 if their peers doubled that, the majority chose the lower salary. When I first saw the story, I chuckled and started to brush it off. But it struck a chord, and ultimately brought back a long-dormant memory of a fascinating 1947 study by Dorothy Brady and Rose Friedman.9
Brady and Friedman presented data that showed that the share of income an American family spends on consumer goods and services is largely determined not by the level of family income but by its level relative to the nation’s average family income. Their study suggests that a family with the nation’s average income in 2000 would be expected to spend the same proportion of its income as a family with average family income in 1900, even though in inflation-adjusted terms that 1900 income was only a minor fraction of that of 2000. I reproduced and updated their calculations and confirmed their conclusion.10 Consumer behavior has not much changed over the last century and a quarter.
Herding is a different type of propensity from all the rest in that it refers not only to individuals’ copycat propensity but also to the principles of group behavior and thus has implications for the economy overall. Fear and euphoria, for example, are contagious processes exaggerated by herding.11 It can be difficult to parse, however, why individuals seek to emulate one group rather than another and what it takes to wean them away from one “crowd” to join another. The emergence of modern social media has only accelerated herd behavior.
Herd behavior is a key driver and an essential characteristic of speculative booms and busts. Once the speculative herd-driven propensity arrives at a state in which the vast majority of market participants have become committed to the bull market, the market becomes highly vulnerable to what I dub the Jessel paradox (see Chapter 3), and the market breaks. While the Jessel paradox explains the upside of speculative booms, an analogy to how the downside plays out, both literally and figuratively, is the extreme form of herding, the dreaded stampede—a term borrowed from the cattle drives of our Old West.
Dealing with day-to-day reality requires a level of detailed decision making that most adults, to a greater or lesser extent, perceive as beyond their ken.12 For most of us, the comfort of guidance is sought in religion, and all of us are drawn to following the directions or emulating the actions of our peers or leaders.
Those who believe, rightly or wrongly, that they know the direction that their society should take compete for leadership. Cliques or political parties arise, from which the ultimate leaders emerge, sometimes by grasping the levers of military power. In democratic societies at least, who the leaders turn out to be, for good or ill, is heavily influenced by herd behavior.
Few if any social groups have flourished without some hierarchy of leadership. Communal groups that make collective decisions by strict consensus—especially those attempting to live communally to the extent of holding income and wealth in common—almost always collapse. People have a propensity to form emotional bonds to a larger group, but when these bonds demand an equal sharing of income or status in a pecking order, they tend to break down, floundering on the inbred self-centered nature of our species. Our propensity for competition invariably produces the jockeying for leadership that has persistently undermined communal societies.
People in every society seek to improve their status in the pecking order of any organization. Even those who deem themselves unaffected by the opinions of others conform to the customs and culture of their societies. Albert Einstein, for example, however intellectually self-generating, followed many of the social norms of his day. Ayn Rand, the most independent person I have ever known, followed many of the trivial dress customs of her society.
Dependency
Our sense of mutual dependency leads us to search for the companionship and approval of people we perceive as our peers. Instead of living as self-sufficient hermits, people almost universally choose to live in groups and gain from companionship and a division of labor.13 And, of course, if we did not harbor an inbred biological imperative to procreate, none of us would be here. But a sense of dependency by definition places “dependents” in a constant state of uncertainty. To assuage the uncertainty, people’s inbred sense of self-worth asserts
itself and we challenge authority. Our nature also requires us to seek a measure of independence. Dependency in one form or another is a necessary but not necessarily a pleasurable state. Children under the restrictive guidance of elders often revolt against parental apron strings. Many children, at one time or another, in extremis, leave home in an assertion of independence, only to return when the reality of their dependence becomes all too real.
The Interaction
Time preference, coupled with risk aversion and herd behavior, governs the pricing of all income-producing assets and, since the nineteenth century, sets the proportion of income that households seek to save over the long run. The real (inflation-adjusted) interest rate is anchored by time preference, and it fluctuates according to the balance of saving and investment in an economy and the degree of financial intermediation. Bond yields measure risk aversion in two dimensions: by credit rating and maturity. Herd behavior will often skew an individual’s risk aversion judgment toward the mean of a group: other investors, family, or pundits. Stock prices can be thought of as the sum of the expected future earnings per share, tempered by a rate of discount applied to those earnings. That discount rate is the rate of return that investors require to hold such risky assets. The equity premium is the rate of return that investors expect, less the real rate of return on riskless assets, a proxy for time preference. The capitalization of rental returns on real estate properties is similarly calculated.
Home Bias
Home bias is the propensity to deal with the familiar: with people and things geographically close to home and familiar in terms of culture, language, and interests. This is especially evident in trade data, both foreign and domestic, even allowing for savings in transportation costs. Canada and Mexico, for example, accounted for 29 percent of our total international trade in 2011, far more than their share of global non–U.S. GDP. And my family’s favorite pharmacy sells the vast majority of its wares to patrons who live within a mile of its location.
Aside from any direct or indirect barriers, people seem to prefer to invest in familiar local businesses. The United States has no barriers to interstate investment, and the states share a common currency, culture, language, and legal system. Yet studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities.
A propensity related to the comfort and familiarity of trading with partners close to home is the emotional comfort we all sense in personal relationships that become familiar and predictable. The uncertainty that arises with strangers imparts a certain, if minor, stress that subsides with familiarity. Personal relationships that build over months and years are a major reason why people born and brought up in a particular locale tend to stay put, often for a lifetime, even when they have accumulated the physical resources to move elsewhere and have ample reason to do so. The familiarity of home is the source of the angst we feel after leaving, namely homesickness.
Competition
More complex, and battling with our sense of dependency, is our introspectively self-evident propensity to be competitive. Its consequences range over a much broader spectrum than most propensities. Competition as it plays out in markets is, of course, indispensable to the efficient functioning of our economies, as has been emphasized by economists for more than two centuries. The degree of competitiveness has a broad sway in defining our culture and its indirect effect on economic events.
We compete whether on a ball field or during a dinner conversation. When we view a familiar competitive sport, even though we may begin by having no preference for either competitor, we usually find ourselves rooting within a matter of minutes for one or the other. If not, we lose interest. It is our nature. And when we combine this propensity with copycat herd behavior and our home bias propensity, we develop overwhelming support for local teams against “foreign” competitors. Spectator sports are effectively morality plays: stylized views of the type of competition in which we all engage in our day-to-day activities with respect to both economic and noneconomic relationships. The specific spectator sport is irrelevant—all that is required is that there is competitive “combat” and that there are winners and losers to gain our attention.
I suspect, but cannot prove, that this propensity is driven by the fact that competition is, in a Darwinian sense, necessary for survival. Unless we successfully compete in the taking of risk, we perish. War appears to be an ugly extension of this propensity. War is competition raised to a level of mortal combat in which there are ultimate winners and losers. Since war has been a part of the human condition as far back as history allows, I assume this propensity is inbred. This is one of many ambivalences that arise with animal spirits.
Code of Values
No human being can avoid the imperative of judging right from wrong. What we feel is right and just reflects our own deep-seated code of values. We rationally codify our introspective view of how our actions will further our values and, therefore, what set of actions we believe, rightly or wrongly, will nurture our lives. The value systems of most people are rooted in religion and culture and are heavily inculcated at an early age by our parents and, later in life, by our peers.
What is perceived by people as right or wrong is not preordained and requires that each of us fill in the blanks by drawing on our own value systems. Herd behavior, not surprisingly, is apparently a major factor in individuals’ choices, and people’s value hierarchy can and does change over time. Moreover, we cannot help applying our own standards to judge the actions of others.
This propensity is the source of our sense of “fairness” in economic matters. Most people act as though a particular sense of fairness is self-evident. It is not. It is rather one’s most deeply imbedded hierarchy of values that most people have difficulty expressing, or even identifying in some instances. Most commentators take it as self-evident that taxing the wealthy at a higher rate than lower income groups is “fairer.” But that implies that somehow upper income taxpayers have not “earned” their income, a view that rests on the belief that in a division of labor of society, all income is produced jointly. The alternate view is that even though output is produced collectively in a free, competitive market, each individual’s income reflects that person’s marginal contribution to total output. Either view can be, and has been, rationally held, but neither can claim self-evidence. “Ability to pay” is a pragmatic view that also rests on the premise that income is not “earned.”
Most people in a society or country tend to hold similar standards of fairness. This, in democratic societies, ultimately determines what is legally “just,” the basis of our set of laws. Such fundamental beliefs are the major glue that holds societies together. In the United States, for example, the pact with respect to public issues is our Constitution. We are governed by a rule of law anchored by the protection of those “fundamental” individual rights. That constitution has existed with relatively few amendments since 1789. But that stability in the governing law of our land has periodically come under strain over the generations and indeed broke down on the set of issues, slavery first among them, that led to the Civil War. That the break did not come sooner is surprising given the inherent contradiction between the Declaration of Independence’s assertion that “all men are created equal” and the existence of slavery.
Optimism
Another propensity is people’s bias toward optimism rather than realism—a propensity to assume that success in all actions is more likely than the objective probabilities. We wouldn’t take risks if we were certain of failure. The mentality behind widespread gambling, for example, is that one can beat the odds, even as they are objectively stacked against us. This is especially the case in a lottery where pure chance prevails. As Kahneman observed, “We also tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence
. In terms of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases.”14 Of greater economic relevance, the propensity toward “hope” encourages entrepreneurial initiatives. That probably assures greater successes, but certainly more failures as well.
Bias to Value Relatives
The evidence is unequivocal that people have an inbred propensity to value relatives, especially children, over others. This perpetuates the concentration of inherited wealth and the distribution of income from one generation to the next.
Self-interest
We direct our actions to achieve those values, material and otherwise, that are required by our nature to survive and thrive. If we fail, we perish. In the realm of economics, the vast majority of our actions are driven by self-interest relative to the interests of others. If self-interest were not the primary determinant in economic activity, how do we explain the universal evidence that demand curves have downward slopes and supply curves trend upward—that is, that buyers will buy more and suppliers will supply less if prices fall? It is that, plus its obverse, that creates uniquely determined prices in all types of markets. Upward-sloping demand curves are a rare phenomenon.15 Profit as a motive necessarily narrows choice. But even here there are trade-offs that pit long-term benefits against immediate gratification. All human beings harbor an inbred propensity to value human life. Even though there are clearly qualifications, that inbred propensity is the source of our feelings of empathy, charity, and in extreme cases, self-sacrifice. This is also the motive behind a father risking his own life to rescue his drowning child. Thus, much beyond narrowly focused economic self-interest has significant economic implications. In crisis, we seek to help one another as we all seek a common outcome. We saw such behavior in the London blitz of 1940 and, more recently, in Boston after the horror of the Boston Marathon bombings.
The Map and the Territory Page 3
