Inflation is running at a 40 year high and the Bank of England forecasts that the UK will enter a recession by the end of the year. Many people across the country are facing enormous pressure, which is only mounting. Tackling this will be a huge policy challenge over the next few months and beyond.
In this blog we reflect on three learnings from the behavioural literature, past crises and the latest data. We also set out three things policymakers can do to make a meaningful difference, and that should be part of any wider policy package to support households.
1. Perceptions and misperceptions: do consumers know what’s coming?
The cost of living crisis feels like it’s been all over the news for months. But in reality, little has been done to give households the information and tools to prepare for what is to come. In a Bank of England survey in May 2022, only 51% of those surveyed thought that prices would rise by 4% or more in the next 12 months. Inflation is already currently running at 10% and shortly expected to rise as high as 13% according to the Bank of England – and as high as 18% next year according to Citi.
Unfortunately, research indicates that those who are likely to be hit hardest by the economic squeeze, such as single-income families or people in part-time work, are most likely to underestimate how much inflation will rise by. This will make it all the harder for them to prepare for the forthcoming economic downturn: in the same survey, only 38% of those earning £10,000 or less per year answered that prices would rise by 4% or more, compared to 50% for those earning over £55,000. This is of particular concern when coupled with evidence from the Resolution Foundation that the majority of families have less than one month’s income in savings and a significant proportion have no savings at all.
2. Not having enough money makes it harder to make good decisions
While people may underestimate the extent of price rises, most are still worried about rising costs, so how do they react? People may shift towards scarcity mindsets, where we fixate on immediate problems and neglect longer-term consequences of our decisions. A replication and meta-analysis of 20 previous studies on scarcity finds that financial constraints have a psychological impact on how we make financial decisions – for example taking out loans with high repayments down the line. Under financial pressure, people borrow more than they need and under-estimate total costs of borrowing.
Whilst not all consumers react the same way, latest data shows that borrowing is on the rise, with 1.3 million low-income households having used credit to cover essentials this year and over 2 million households in debt to high interest lenders like loan sharks or doorstep lenders.
3. Is behaviour change limited to the short term? The case of depression babies
Can economic crises affect people’s behaviour in the long-term too? Economic crises are deeply psychological in how they play out and their long-term impact: the way people spend, save and invest is influenced by prevailing stories and narratives about the economy.
Enter a famous study on Depression Babies. Authors Ulrike Malmendier and Stefan Nagel examine data from the US Survey of Consumers Finances, spanning 1964 to 2004, and find that where individuals experience low returns on stock markets and higher volatility they are less likely to participate in the stock market and take financial risks. These effects fade slowly and can impact future decision making for several decades. This finding has been replicated in Japan, where it was also found that people are less likely to be self-employed and less likely to change jobs if they experienced harsh economic conditions when young.
The state of the economy when growing up can also impact the types of jobs people take. Those growing up in times of economic crisis are more likely to prioritise income when job seeking, whereas those growing up in more prosperous times are more likely to value the meaning they take from a job.
So what can policymakers do?
Households will need substantial financial support – how this is designed, structured and delivered is crucial to its success. Significant government support will be needed to help households through the crisis – and that support needs to be set at a level that makes a genuine difference. One-off payments that are set too low can have unexpected and negative effects – for example a study in the US found that one-off cash transfers of $500 – $2,000 made no long-term difference to bank balances: instead receiving some money but not enough generated greater feelings of distress than people who received nothing. There are also ways of delivering money that make it easier for households to manage bills and budgets, for example, weekly or fortnightly payments rather than monthly (based on previous research in the context of Universal Credit). Providing access to high quality financial advice and guidance, alongside money, to help people make decisions about borrowing and debt is crucial.
Ensure well-designed financial products and services. It is often tough to make good financial decisions like the best loan offer or savings product. It is even harder if you’re in significant financial distress. That makes initiatives like the FCA’s new Consumer Duty on firms to actively demonstrate how they are providing fair and suitable products and services even more important. We explore how behavioural insights can support financial firms to make this happen in this blog. For example, under our Financial Capability Lab with the Money and Pensions Service, we tested whether changing the presentation and default options for the amount to repay on credit cards would help people better conceptualise the impact of earlier repayments on total debt to pay down.
We found that using a timing slider (shown above) and allowing people to select when they wanted to repay their debt rather than showing default repayment levels was the most effective.
Use this opportunity to invest long-term in energy sustainability and security. This crisis, like no other, has focused political minds on the impact of under-investment in our energy security. A lot of the public are likely to feel the same. So once sufficient financial help for households is in place and the worst of the crisis is over, this could be an opportune moment to encourage individuals to adopt measures that reduce energy consumption such as insulation, to reduce longer-term energy bills. For example, in future years, once energy prices have normalised again, prompting people to put their winter fuel allowance towards retrofits that save them money in the long-run.