Thinking like a Nobel Prize Winner Can Improve Your Family Finances

family finance
Gary Becker September 30, 2013

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Professor Gary Becker, 1992 Nobel Prize Winner in Economics, shows you how to apply economic theory to family finance. Learn new ways you can make sound financial decisions, and resolve family conflicts about money.

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Interview with Gary Becker

Professor Gary Becker, winner of the Nobel Prize for Economics in 1992, explains how to apply economic theory to family finance. Do people make sensible or irrational decisions when thinking about their finances?

Douglas Goldstein: Some of the work that you’ve done in economics, which has really been quite novel, is applying the theories of economics to other areas, not the least of which is the family. One of the things that I understand that you’ve argued is that if you look at the family as a small factory, you’ll see that they make decisions that are rational. Is that really true?

Gary Becker: I think it is really true for the most part. Not every decision is rational, but I think people recognize that a lot of decisions made by families, such as when people get married, when they divorce, or when they have children, are some of the most fundamental decisions they make over their lifetime. I think most people put a lot of thought into those decisions.

Douglas Goldstein: How about personal finance issues, like why don’t people balance their budget, and why do they borrow too much on their credit cards?

Gary Becker: Most people, I think, are pretty sensible about it. There are exceptions that get more publicity. Sometimes it pays to borrow, depending upon one’s circumstances. If you’re a young person, you expect your earnings to be higher in the future. It’s rational to go into debt, and young people do get into a lot of debt when they’re in school or in early stages of school. That’s probably rational. I think if you look at the bulk of people’s behavior, I think you find a lot of sense to what they’re doing in the sense that one can understand, given the circumstances and the uncertainty they face in the future, they make pretty good decisions. They’re not perfect, of course, but they are pretty good decisions.

Was the Subprime Mortgage Crisis Caused by Irrational Government Decisions?

Douglas Goldstein: Do you find that due to the policy that the government might make, even for example now, or let’s say a few years ago during the housing crisis, which caused people to get very easy money and to borrow such huge amounts, that people made what certainly retrospectively seem to be irrational decisions? Maybe even at the time they were irrational.

Gary Becker: They were making decisions, and some of them turned out to be not so good. You had a lot of sophisticated people in the financial community, investment bankers and so on, who made a lot of decisions that eventually cost them and their stockholders a lot of money. So I look at the consumer decisions, but the sub-prime borrowers, who had poor credit ratings and low income, were able to borrow money with very little downpayment of very little interest, so there was a great rational incentive to do. Now, for some of these people, it turned out when the boom burst and they were starting to pay, the houses were taken away from them. They enjoyed a year or two or longer of living pretty cheaply in a house. I think the irrationality was not on the consumers’ side but on what governments did in terms of Federal Reserve and what a lot of investment bankers did.

Douglas Goldstein: So you’re saying that the people themselves, given their specific situation, individually made rational decisions even though perhaps from an outside point of view the whole setup might not have been so wise?

Gary Becker: Exactly. There are people who went into a debt well beyond anything they could expect of finance. I am not denying that there are those examples, but I think for the most part with the housing boom, individual householders, regardless of education or income, and particularly the ones who came in on the easy money, low interest rates, and subprime environment actually made pretty good decisions. It is hard to understand what the governments were doing and what some of the so-called sophisticated bankers were doing.

The Family Unit as a Small Factory

Douglas Goldstein: Let’s go back to the family unit and looking at it as a factory. I tell my clients, “You’re like the CEO of your company, and you have to make the big picture decisions. You hire a manager to handle the day-to-day operations.” I like to use this metaphor because my clients like to understand that they are in control of the big picture and they shouldn’t worry about the details. The problem that I find when I talk to clients is that a husband and wife come in, and the husband says, “Yeah, but you spend too much.” Then she says, “You don’t work hard enough,” and again that to me seems rather irrational.

Gary Becker: There are conflicts within families. Whether it’s rational or not depends on whose point of view you’re looking at. Maybe the husband doesn’t work so hard because he might expect his wife to make up for it in some way. So he does what we call in economics trying a free ride on what she will be doing, and he cuts down on his work. She spends more because she hopes that will induce him to earn more, and her interests are not fully meshed with his interests. What I’m trying to say a little bit convolutedly is that a family is a unit, but that doesn’t mean there’s no conflict in the family. It’s just like a company is a unit, but we know there’s a conflict between stockholders and management, or managers and low-level employers. So there is conflict in the family too. If you look at it, it may not be rational for the whole unit but maybe a rational thing to individual participants in terms of the decisions they are making.

Professor Becker’s Parking Space Decision

Douglas Goldstein: There’s a famous story that I think is about you. Tell us if it’s true. One day, you were parking your car and you had a choice because you were in a hurry to either park illegally or to take the long route and look for a garage. Ultimately, the story goes that you chose to park illegally because you calculated that the probability of getting caught and the potential punishment didn’t compare against the benefit of getting a good, albeit illegal parking space. You didn’t seem so afraid of the repercussions. My question to you is: On the show, I had the opportunity to speak to Professor Danny Kahneman about loss aversion, and he said that people really hate to lose. But you seemed not be afraid of losing in the parking case. Is it a true story? Why do you think there’s a difference between the ways you both look at human nature?

Gary Becker: Unfortunately, this is a true story. I was in a rush to examine a PhD student, and that was exactly the kind of calculation I made. More than that, on the basis of that calculation, I thought about that problem. I eventually wrote a fairly well-known paper on what’s called Crime and Punishment: An Economic Approach and it led to a publication for me. In terms of the question you’re raising, I think when people make small calculations like I was doing, the final answer would not be important in terms of my wealth and so on. I think people make the kind of calculations I make for the most part. When people are worried about a bigger risk that they are taking, various types of financial risk or other risk, I think they very much worry a lot about losses. I don’t see anything irrational about that, I just think that’s the way people are constructed - that fear of losing can dominate the game from gaining and so people take that into account. If I was thinking of my calculation that I might get 6 months in jail or 3 months in jail, (you know that jail has a very low probability) then I might have made a different decision.

Douglas Goldstein: So you’re saying that the size of the transaction is what’s going to affect whether someone is willing to take the loss, as opposed to what Kahneman was talking about, which was perhaps referring to major investments?

Gary Becker: I definitely think, and a lot of work in economics and psychology suggests that the size is really important.

Douglas Goldstein: This sounds so obvious, so why would anyone think otherwise?

Gary Becker: I think people do recognize the size of the losses versus the gain, seeing that it really affects people’s decisions. Let’s say I’m going to spend maybe $25 at a casino with slot machines, where the probability of winning is very low but the enjoyment of just seeing if I could win is big. There, that kind of behavior is going to be very different. But if I am talking about whether I should invest in this company, which has very low ratings, I may lose my whole investment, and that’s a big part of my wealth, I’m going to think very differently in that situation. I think very few people would deny that it is common sense, but sometimes we deny common sense.

The Greatest Good

Douglas Goldstein: You founded an organization called The Greatest Good in order to help people with philanthropy. From my experience as a financial advisor, some of the wealthiest people that I know tell me that when things get bad, they increase the amount that they give in charity. Sometimes they’ll quote from the Bible where it says in the Prophets, “Test Me. If you give charity, then I’ll give it back to you.” This all doesn’t sound terribly rational, but it sounds perfectly religious and very nice.

Gary Becker: There are some people like that, but if you look at the behavior of charitable gifts during the past crisis and during recessions, people generally cut down. One of the things they cut down quickest is their charitable contributions. There are exceptions to that, clearly of people who feel that they are obligated to give fixed amounts to religious charity. They may continue to do that and may even give more, because they think they might help them in the future, but I think if you look at the bulk of people, that’s where economics deal. They deal with the bulk of people, not with every single individual, and charitable contributions are very sensitive to the state of the economy and the state of an individual’s fortunes. There’s a lot of evidence supporting that. That’s rational, I think. If your situation is more precarious and you’re going to cut down on some things that you can maybe make up later in charities, that’s one of the things you can do.

Douglas Goldstein: One of the irrational things that I’ve often thought of is that when people donate large sums of money or even small sums, they often don’t really care how it gets invested. I’ll say to them something like, “If you like, we could oversee the donation to make sure that your building gets built or the library gets funded,” and they say “No, it’s okay, I’m friendly with the principal. I know it’s going to happen.” That same person who is donating a million dollars would look so carefully at every aspect of an investment that he did, let’s say if he’s buying stocks or bonds. Why do you think there’s such a disconnect?

Gary Becker: It depends on how much confidence he has in investing. I’m a chairman of an institute at the University of Chicago, and we’re trying to raise money for that institute. My experience has been that potential donors ask a lot of questions, particularly always before they give us a big gift, and they worry a lot about how the fund is going to be spent. They don’t want to get involved. The details of how it’s spent is perfectly sensible. Let’s say somebody is going to give money to the department of economics at my university, or Hebrew University, or anyplace else. They don’t know enough to know what’s a sensible way to spend that money. They just don’t know the details of what it means to recruit students and faculty and the live research. What they worry about is if they have confidence in the person they’re giving money to so that they can make the right decisions for them. I think that’s a far more central decision and the philanthropist won’t think they can micromanage successfully a gift to a university or any other charitable institution because most of the time, they really don’t know enough to be able do that very well. They may know a lot in their business so they micromanage that carefully.

Douglas Goldstein: How can people follow your work?

Gary Becker: I have a blog called The Becker-Posner blog and we publish every week discussion of different articles.

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