by Fabrice Grinda

As I was reading The Upside of IrrationalityDan Ariely’s sequel to the brilliant Predictably Irrational, I started wondering whether there were macro implications and applications for behavioral economics and specifically to the concept of hedonic adaptation.

As I described over the years in my musings on happiness, hedonic adaptation is the process by which we rapidly adapt to changes in our life circumstances and return to our mean level of happiness. Because we disregard its existence, we humans are particularly bad at predicting how positive and negative changes in our lives will affect our happiness. People in Michigan predict that people in California will be happier than they are given the weather. Empirical evidence suggests that a move to more clement weather does temporarily improve people’s happiness, but their happiness level rapidly reverts to the mean as they get used to the gorgeous weather. Likewise, when asked to predict how they would react in the face of negative events such as losing the ability to use their legs, people underestimate their ability to cope. They predict they would be miserable forever while research suggests that after an initial dip in happiness, people rapidly revert to their mean level of happiness.

Behavioral economics suggests ways to delay or speed up our adaptation. If you are considering indulging yourself by buying a new wardrobe and plasma TV for instance you are better off spacing the purchases. Likewise, if you are receiving a massage, you are actually better off interrupting it for a few minutes in the middle.

The reverse applies to negative changes in your life, especially economic cutbacks. People intuit that they should spread the pain, but research suggests that are much better off reducing consumption all at one. In other words, you should move to a smaller apartment, give up cable television and cut back on expensive coffee all at once rather than in increments. The initial amount of pain will be higher, but as we rapidly adapt to our circumstances, the total amount of agony will be lower.

It strikes me that our society and politicians have been making the wrong choices over the last few years in terms of economic policies as we seem unable to take a bit more pain in the near term and thus end up enduring pain for much longer than we might otherwise have to. It was not always the case. In 1981, when Paul Volcker increased the Feds Funds Rate to up to 20% in June 1981, he plunged the US in a deep recession increasing the unemployment rate from 5.8% in 1979 to 9.7% in 1982. However he tamed inflation which peaked at 13.5% in 1981. By 1983, inflation was lowered to 3.2% and the stage had been set for a period of sustainable growth.

More recently though we have artificially propped up many sectors of the economy through bailouts, subsidies and policies which delay those markets reaching equilibrium. We thus create an impression of continued economic malaise as these markets slowly reach equilibrium. In other words, we have longer lower level pain instead of more pain for a shorter period of time.

Even assuming that the total amount of pain is the same in the case where we let markets clear on their own versus propping them up and it’s just the intensity and duration that changes (and I suspect that it’s not), we are clearly making the wrong choice. The continual arrival of bad news prevents us from adapting to our circumstances and we are thus suffering much more than we would otherwise if we had experienced the entire negative outcome in a brief period of time. Moreover, I suspect that continued arrival of negative or mixed economic news is detrimental to society at large and not just for those who have lost their jobs and/or home as the economic uncertainty makes them fear for their own well-being. In other words it’s better to have brief deeper recession than 20 years of Japan like stagnation.

This is not to say we should not act when the economy is in recession. Running counter cyclical fiscal and monetary policy has proven effective time and time again. The issue has more to do with policies that prop up real estate, car manufacturers, and banks, and delay the inevitable reform of public pensions and our overall fiscal adjustment. Despite the potential for moral hazard, you actually can’t let your financial sector go out of business because it is the engine of credit creation without which you don’t have an economy. My concern is less with the need to bailout banks (unfortunately we had to), but the fact that we did not do a good job at cleaning their balance sheets. Instead of disposing of most of their toxic assets with a good bank / bad bank approach (or a number of approaches with the same outcome), we are hoping to let them earn their way out of the problem by keeping short term interest rates low (banks make a lot of money in low rate environments because their borrowing decrease which increases the spread with the rate they earn on the long term loans they made). The result is not dissimilar to the zombie bank problem that infected Japan for the last twenty years. It took twenty years for these banks to clean their balance sheets and start lending again. Credit creation remains broken in the US and might worsen if housing takes a turn for the worse, which it very well might as we don’t seem to have reached the market clearing equilibrium as suggested by continuing price decreases.

 

Likewise, the entire slew of policies enacted to stem the decrease in housing prices have merely delayed many foreclosures, price decreases and decreased labor mobility as people have stayed in their home longer than they should in the hope of a price recovery. Instead of seeing a rapid adjustment to the market clearing price and acting accordingly, homeowners are enduring agonizing small decreases in prices year after year. Again, in this, we seem to be copying the Japanese example where house prices fell a few percent a year every year for 18 years from 1989 to 2007. In the end residential real estate prices fell over 90% in Tokyo between 1989 and 2007 and commercial real estate fell over 99% in some cases!

As our politicians and public unions face fiscal retrenchment, they should really focus on decreasing human misery by making more cuts and adjustments upfront rather than spreading them little by little over many years.

Hedonic adaptation is one of the most powerful tools at our disposal for stemming human misery. Let’s make the most of it!