Saturday, May 11, 2013

Digital currecncy bad news for debt-ridden consumers

(A version of this article appeared in the Sunday-Star Times in July 2011.)

The Weekend Herald contained a small news item about the CEO of PayPal Scott Thomson who claimed that wallets will soon be obsolete. Thomson suggested that by 2015 digital currency will be accepted everywhere, at least in the US. Soon you will not have to carry around either cash or cards but be able to make all your payments via your cell phone.


Experts believe that PayPal’s CEO is being overly optimist about the timeline. Nevertheless the fact remains that the advent of digital currency is not too far away in the future.


What are the implications of digital currency for consumer debt? Not good, I am afraid. Drazen Prelec and Duncan Simester of MIT suggest that digital transactions fundamentally change the way we spend money. When we pay via credit cards we tend to spend a lot more than if we paid with cash.


When we pay with cash, there is a sense of loss when we have to hand over the dollar bills to complete the transaction. Credit cards make the transaction abstract and as a result digital transactions do not affect our brain the same way that paying with money does.


The part of our brain which deals with feelings of aversion (such as a reaction to a bad smell) is called the insula. Economic decision making experiments using brain imaging suggest that when we pay with our cards, as opposed to cash, there is reduced activity in the insula. This implies that we do not feel as bad about spending money when we use our cards rather than cash. Ergo, we end up spending more.


Prelec and Simester organized a sealed bid auction of tickets to a Boston Celtics game. Half the participants in the auction had to pay with cash while the other half could pay with a card. When Prelec and Simester looked at the average bids they found that the average credit card bid was twice as much as the average cash bid.


Cell phone transactions will further increase the disconnection between the pleasure of buying and the pain of paying and will almost certainly exacerbate the tendency to spend money. 


Think of this as a tussle between the emotional and rational parts of our brain. The emotional part looks at things – shoes, handbags, golf-clubs and silk ties – and wants to buy them. The rational brain thinks about the cost of paying for these and holds us back.


Brian Knutson, a neuroscientist at Stanford, along with colleagues carried out an ingenious experiment to understand how people make purchasing decisions. Participants were given an amount of money to start with and then shown various different objects they could choose to buy. If they bought something then the item’s cost was subtracted from their starting balance.


While people made these decisions the researchers were studying their brain activity using fMRI scans. They found that when people first encountered the goods for purchase, this activated their nucleus accumbens (NAcc) which is the part of the brain that deals with pleasure and rewards.


Then they are told the price of each item. At this point the insula and the prefrontal cortex (PFC) got involved. The insula, as I mentioned, is engaged when we find something distasteful like actually having to fork out money for things we want to buy.  


The PFC is the rational part of the brain which is involved in decision making or handling complex cognitive tasks. Faced with the NAcc wanting to buy the pair of shoes badly while the insula objects at the price tag, the PFC tries to figure out if this is actually a good deal or not.


By looking at the activity in the different regions the researchers could predict how people would decide. If the activity in the insula was stronger, then people would end up not buying the good. But if on the other hand the NAcc was more active or if the PFC was saying that this was indeed a good deal, then the participant ended up buying the good.


So what’s the catch? If you want to get people to buy things then you have to increase the activity in the NAcc. Think about the prominent displays in duty free stores for a minute. These are designed to appeal to your pleasure centre and make it harder to stop yourself from buying something.   


But stimulating the NAcc is not enough; you also need to deactivate the insula. One way of doing that is to postpone the act of paying. Credit cards, digital currency or instant financing all contribute towards that end. Signs saying “sale!” or “huge reductions!” achieve similar goals of inhibiting the insula or convincing the PFC that this is indeed a great deal.


The end result is the same. We end up buying things we don’t need and often cannot afford, simply because the rational part of the brain loses out to the emotional part.


Do you have a problem with debt? Do you find yourself compulsively buying things and later regretting? Then here is my advice: forget the cell phone, hang on to your wallet and if you have to buy something, try and pay with cash.


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