Whose money is it anyway?
The trick is to stop thinking of it as ‘your’ money.
IRS Tax collector
One of the things that surprises me as a German about Americans and Brits is how willing they are to spend money they don’t own. Obviously, they don’t put it that way, but the United States and the UK were much faster in adopting credit cards than Germans, for example. And the consumer loan business is much larger in these countries than it is in Germany.
This difference in attitude towards debt has consequences for personal finances and on the economy overall. In countries like the United States, consumption is a bigger share of national income and the indebtedness of households is generally higher there than it is in Germany. This also means that the United States and the UK are more prone to debt-fuelled bubbles that from time to time end in chaos, as we have seen in 2008.
However, not all debt is created equal. How willing we are to spend money we don’t own, very much depends on how we think of it. In a series of studies, Eesha Sharma and her colleagues showed that consumers typically think of credit card money as ‘their money’, while they think of a loan as ‘other people’s money’. Consequently, they are also more prone to spend money using their credit card than to spend money that they could spend by tapping into a loan.
Of course, consumer finance companies exploit this mental accounting effect by presenting credit card debt and loans not as debt or borrowed money, but instead as a source of additional funds that can and should be spent. Meanwhile, consumer finance protection advocates can shape the attitude of consumers towards credit cards and loans by framing it as borrowed money, which reduces the willingness of people to tap into the loan and spend it. Thus, instead of making it mandatory to show the APR of a credit card or a consumer loan, regulators may be able to protect consumers from falling into debt traps by mandating how credit cards and loans are advertised and explained to consumers. By framing them explicitly as debt and borrowed money, consumers are less likely to overspend.
But the more important insight, in my view, is what this study implies for the economy overall. In a crisis, the government and the central bank are the lenders of last resort. Traditionally, they would intervene in a crisis by providing loans to businesses and households who got into trouble, just like they did in the financial crisis and in this year’s crisis. The drawback of this method of rescuing the private sector in crisis is that businesses and households are reluctant to take on loans and eager to pay them back as soon as they can. The advantage is that from a government’s perspective, this means that only money that is really needed will be spent to rescue the economy and the government has a good chance of getting much of its loans back once the crisis passes (for example, the TARP loan programme introduced after the financial crisis in the United States has received more than 99% of its loan money back by now).
Meanwhile, sending people and businesses money through a tax refund or tax deferral (to go back to the introductory quote) means that people will use the money as if it was their own. That means they are more likely to spend it, which has the beneficial effect in a crisis to stimulate consumption more effectively than loans. But, and this is something we might see in 2021, it also means that when the government wants to collect deferred taxes, it might be faced with businesses and consumers that haven’t prepared for that eventuality and then get into trouble because of missed tax payments. Because many countries used tax deferrals and tax holidays to help people and businesses in the spring of 2021, they might have just pushed part of the crisis into the future because a higher tax bill in 2021 will reduce consumption in 2021 and thus hinder the recovery after the crisis.