Why feeling good is important for economics ::Business Line

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Classical economics suggests that consumer spending can improve economic growth. Now, you and I will spend only if we earn more.

But economists may well argue that to earn more, we need to spend more! So, what does it take to break the circular argument? Behavioural psychology shows that spending habits can change with the state of mind! How?

Suppose a neighbourhood restaurant charges Rs 30 for a cup of coffee while a coffee bar charges Rs 65. Which would you choose?

You will most likely say that the choice would depend on whether you can afford the costlier coffee. While that is generally true, another factor kicks-in when you spend money. And that is your state of mind.

Suppose you just stepped out of a successful business meeting. You will most likely choose the costlier coffee, as you feel good. Remember, you wealth is still the same; it is your state of mind that has prompted you to choose the costlier coffee.

THE WEALTH EFFECT

Such spending need not stop with coffee. Consumption of comfort goods such as air-conditioners and luxury goods such as exotic holiday destinations can improve with the state of mind. The effect is nothing new.

Consumption in the US has tended to increase when the stock market trends up, as was seen in late 1990s and before the subprime crisis. It is called the wealth effect.

The term refers to individuals spending more because their perceived wealth (unrealised equity investment profits) has increased. By the same logic, when the market declines, as it has in the recent times, negative effect kicks-in. Do not be surprised, therefore, if you find noticeable reduction in consumption levels in the economy.

Classical economics argues for tax cuts, as that will place more money in the hands of people.

But tax cuts are unlikely to improve the economy, unless people spend the additional cash. And they will do so only if they have a positive mind. It is, perhaps, worth hiring psychologists to talk up the economy!